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CIAO DATE: 8/01
Did the Fed's Obsession with Stocks Cause It to Miss the Slowdown?
James K. Glassman
Kevin A. Hassett
On The Issues
February 2001
The Federal Reserve's excessive concern with keeping the stock market at a "reasonable" level has led it astray from its proper role—pursuing full employment and controlling inflation—and probably caused it to react tardily to signs that the economy was cooling off late last year.
By cutting short-term interest rates a half-percentage point between regular Open Market Committee meetings, the Federal Reserve on January 3 admitted, in effect, that it had made a terrible mistake. Only fifteen days earlier the Fed had declined to reduce rates, and only a month before that it announced that "the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures in the future."
Inflation? Our colleague, economist John H. Makin, believes that at the very time the Fed was fretting about tight labor markets, the economy had already entered a recession. At the very least, it was evident to practically everyone who runs a business in America that the economy was already slowing significantly as the leaves began to turn in the bucolic northwest Washington neighborhood where Alan Greenspan lives. How could the Fed have missed the vital signs? Why didn't the central bank begin cutting rates in October or November to avoid the need for the emergency measures it took this week—measures that may, at this point, be too little, too late?
We have two explanations. The first is that, incredibly, the Phillips Curvers still have influence at the Fed. This faction, whose most prominent member is Laurence Meyer, continues to believe that growth, especially when manifested by low unemployment, causes inflation and, since unemployment is still just 4 percent, a Fed rate cut would simply feed the fire. Of course, recent data have not been kind to Phillips Curve advocates. Over the past three years, especially, Mr. Greenspan has acknowledged that, in this new economy, technology boosts productivity, and supply tends to keep up with demand, rendering inflation less threatening.
It is the second explanation for the error, therefore, that is more compelling: Like a deer in the headlights, the Fed simply became transfixed by the stock market. Mr. Greenspan and his colleagues became convinced that stock prices were too high and that, by cutting rates, they would push them even higher. So they waited. And waited.
It's not hard to find evidence of Mr. Greenspan's fascination with stock prices. Turn to the speech he gave at the annual dinner of the American Enterprise Institute on December 5, 1996, when he warned of "irrational exuberance" in the markets. At the time, by the way, the Dow Jones Industrial Average stood at 6,437.
Later, Mr. Greenspan would revise his views: Exuberance might not have been so irrational, but higher asset prices put the economy in jeopardy by increasing the propensity of consumers to spend and encouraging inflation. This argument fails to account for the fact that, while the wealth effect boosts consumption, it also boosts production. Higher asset prices mean more capital investment, which increases supply and dampens inflation.
Ignoring Signs of Economic Slowdown
Meanwhile, as autumn began, the real economy was heading south, with no signs of inflation. Jobless claims shot up in September. New factory orders fell sharply in October. Core producer prices were flat or falling. In other words, conventional economic statistics were flashing a warning that a slowdown was in the works.
The minutes of the Open Market Committee meeting of November 15 take note of alarming developments: "Business investment in durable equipment and software decelerated sharply in the quarter. . . . Expenditures on communications equipment declined. . . . The pace of inventory investment slowed considerably. . . . Industrial production edged down in October, after its growth had dropped abruptly in the third quarter to a pace well below that recorded during the first half of the year. . . . A further sharp decline in the production of motor vehicles followed on the heels of a third-quarter slump." Normally, such trends induce rate cuts, yet the Fed voted to keep a tightening (that is, anti-inflationary) bias.
Why? The answer may be found in the stock market, especially the closely watched Nasdaq Composite Index, dominated by technology stocks. After dropping to 3,000 in May, the Nasdaq moved back above 4,000 in late August and was around 3,500 as late as the first week of November. While that was 30 percent below the March high, the index was still up 60 percent since the start of 1999 and 170 percent since the start of 1997.
That, apparently, was too high for the Fed, which noted in the November minutes that "a shift in the Committee's published views might induce an undesirable softening in overall financial market conditions, which in itself would tend to add to inflation pressures." This is the Fed's way of saying that changing the bias to neutral might boost stock prices. The Fed was saying, flatly, that it was "undesirable" for prices to rise since, apparently, its members thought the market, especially for technology stocks, was a bubble.
The Fed may also have feared that a change in bias would reinforce the notion, then gaining currency, that investors enjoyed a "Greenspan put"—a virtual guarantee that the Fed would do its best to rescue a market in danger of drowning. The notion of a put, of course, is nonsense since a monetary policy whose aim is to inflate stock prices would soon cost the Fed (and the dollar) its credibility and have the opposite effect.
The market was dead wrong about a Greenspan put. To the contrary, the Fed was doing its best to depress stock prices. It remained behind the curve at its December 19 meeting, holding rates steady but moving the bias toward easing. Stock prices didn't soar; in fact, on the first trading day of the new year, the Dow dropped 142 points and the Nasdaq, 179. Did that give the Fed permission to cut rates the next day? Perhaps. Or perhaps the Fed finally took a close look at the dismal economic statistics it had been brushing aside.
Fears of a Market Crash
Determining the "proper" level of the stock market is not the Fed's business. It is the business of millions of investors who set the prices of stocks based on their views of the prospects of thousands of companies. Mr. Greenspan's apparent preference for markets that are too low to crash may have resulted from an event just a week after he became chairman: the one-day 23 percent drop in the Dow on October 19, 1987. According to Bob Woodward's new book, Maestro, Mr. Greenspan to this day remains uncertain as to what turned the market around on October 20. But, naturally, he would rather not go through another crisis of the sort.
Certainly, a comatose stock market makes the Fed's job easier, and the Fed can cause a market downturn if it takes the fundamentals down far enough. The market, however, will not likely remain comatose unless fundamentals stay down.
Over the past year, despite Fed tightenings, soaring oil prices, and a presidential election whose outcome was in doubt a month after the balloting, the market as a whole has fallen very little outside of the difficult- to-value technology sector. The average stock mutual fund has lost less than 2 percent, and many of the solid, profitable companies we discuss in our book, Dow 36,000—Automatic Data Processing, Tootsie Roll Industries, Fannie Mae—have risen smartly. The higher productivity of the new economy has not eliminated the business cycle, but it has certainly modulated it. The irony is that, right now, it is the Fed that has the power—by keeping rates high—to destroy the very companies that have created the productivity boom. The Fed should stick to its knitting and let the stock market take care of itself.
James K. Glassman is a resident fellow at AEI. Kevin A. Hassett is a resident scholar at AEI. An earlier version of this article appeared in the Wall Street Journal on January 5, 2001.
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