Fed to Market: Drop Dead (Mark Zandi)

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Fed to Market: Drop Dead

Fed To Market: Drop Dead By Mark Zandi 4/14/00 6:25 PM ET

The selloff in stocks will raise a chorus of calls for the Federal Reserve Board to refrain from an almost certain further tightening in monetary policy. They will not do so. Hikes in the federal funds rate at the mid-May meeting of the FOMC and again in late June are still likely.

Indeed, the selloff in stocks is in anticipation of further Fed action. Investors reason correctly that policymakers will not be able to ignore the torrid economy, which shows no sign of weakening, and building inflationary pressures. Retail sales continued to surge through March and are rising at a double-digit year-over-year pace. Housing, which seemed set to slump under the weight of higher mortgage rates, is bouncing back. Fiscal policy is turning more stimulatory, and export growth is set to surge with the quickly improving global economy. There is no visible constraint on the economy's growth.

Inflation also appears set to accelerate significantly. Abstracting from the ups and downs in energy prices, the core CPI annual inflation rate rose to 2.4% in March. This compares to a nadir of 1.9% last summer. The increases are also broad based across a wide range of products and services, from apparel to recreational services. Nonpetroleum import prices are clearly rising, after falling throughout 1998 and much of 1999. Industrial prices, while still low, are also on the rise. With labor markets continuing to tighten and factory utilization rates rising, businesses are under increasing pressure to raise their prices more aggressively.

The Fed will also not be dissuaded from tightening given that despite the recent selloff in stocks, prices are still higher than they were a year ago. According to the Wilshire 5000, a measure of the value of all publicly traded stocks, the market is now worth $12.5 trillion. A year ago they were worth $12.1 trillion (see Chart). The wealth effect, which policymakers have vocally expressed concern over, will be dented if the market's recent declines are maintained, but it will not be quickly vanquished.

Besides, unless the market's decline turns into a rout and begins to undermine the financial system, this is exactly what policymakers have been looking for. Chairman Greenspan has clearly stated that he thought asset values should grow at a rate consistent with the growth in incomes. Only then would the wealth effect abate. The recent decline in stock prices puts equity price gains more closely in line with income gains.

Only a much more serious further decline in equity prices that would jeopardize the nation's major financial institutions would induce the Fed to curtail its tightening. But even then, it is unlikely that the Fed would step in and ease monetary policy. Policymakers would risk exacerbating an already developing moral hazard problem as investors could begin to feel that the Fed will never allow stock prices to fall significantly, thus fanning further speculation. Even more significantly, if the Fed did successfully turn the market around, then the economy would be further stimulated by the suddenly lower rates. The risk that the economy would overheat could be even greater than it is today.

The Fed should and will continue to tighten monetary policy further. A federal funds rate target of 6.5% by mid-summer is still likely. All that recent events in the equity market have done is reduce the chances that even more tightening will be necessary.

-- Ken Decker (kcdecker@worldnet.att.net), April 17, 2000

Answers

Thanks for the link, Ken. Dr. Greenspan was unusually straightforward in his comments on Friday and it seems clear that the Fed cares far more about the overall health of the financial system than about equity values.

I heard a radio pundit say on Friday that he expected the Fed to step in immediately and "flood the system with liquidity" to help the stock markets. There it is, folks: the "Greenspan put" in all its foolishness. That's precisely the "moral hazard" that Mr. Zandi notes in the above article, and the Fed has to disabuse market players of this notion that they'll get bailed out before the market drops too far.

Now we'll see whether Dr. Greenspan is really made of stern enough stuff to stay the course and withstand the pressures which will surely be brought to bear if the markets continue to decline.

-- DeeEmBee (macbeth1@pacbell.net), April 17, 2000.


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