** Greenspan Does Look at Equity Pricing ** I think we had a discussion some time ago about whether or not the Green Man considers equity pricing in doing his analysis. Looks like he accepts the "wealth effect." From his testimony yesterday:
Preemptive Policymaking
In its deliberations this year, the FOMC has had to wrestle with the issue of what policy setting has the capacity to sustain this remarkable expansion, now in its ninth year. For monetary policy to foster maximum sustainable economic growth, it is useful to preempt forces of imbalance before they threaten economic stability. But this may not always be possible--the future at times can be too opaque to penetrate. When we can be preemptive, we should be, because modest preemptive actions can obviate more drastic actions at a later date that could destabilize the economy.
I should emphasize that preemptive policymaking is equally applicable in both directions, as has been evident over the years both in our inclination to raise interest rates when the potential for inflationary pressures emerged, as in the spring of 1994, or to lower rates when the more palpable risk was economic weakness, as in the fall of last year. This even-handedness is necessary because emerging adverse trends may fall on either side of our long-run objective of price stability. Stable prices allow households and firms to concentrate their efforts on what they do best: consuming, producing, saving, and investing. A rapidly rising or a falling general price level would confound market signals and place strains on the system that ultimately may throttle economic expansion. (My comment: So Greenspan wants a slow, orderly correction?)
In the face of uncertainty, the Federal Reserve at times has been willing to move policy based on an assessment that risks to the outlook were disproportionately skewed in one direction or the other,
rather than on a firm conviction that, absent action, the economy would develop imbalances. For instance, both the modest policy tightening of the spring of 1997 and some portion of the easing of last fall could be viewed as insurance against potential adverse economic outcomes. As I have already indicated, by its June meeting the FOMC was of the view that the full extent of this insurance was no longer needed. It also did not believe that its recent modest tightening would put the risks of inflation going forward completely into balance. However, given the many uncertainties surrounding developments on both the supply and demand side of the economy, the
FOMC did not want to foster the impression that it was committed in short order to tighten further. Rather, it judged that it would need to evaluate the incoming data for more signs that further imbalances were likely to develop.
Preemptive policymaking requires that the Federal Reserve continually monitor economic conditions, update forecasts, and appraise the setting of its policy instrument. Equity prices figure importantly in that forecasting process because they influence aggregate demand. (Can you say wealth effect?) As I testified last month, the central bank cannot effectively directly target stock or other asset prices. Should an asset bubble arise, or even if one is already in train, monetary policy properly calibrated can doubtless mitigate at least part of the impact on the economy. And, obviously, if we could find a way to prevent or deflate emerging bubbles, we would be better off. But identifying a bubble in the process of inflating may be among the most formidable challenges confronting a central bank, pitting its own assessment of fundamentals against the combined judgment of millions of investors.
By itself, the interpretation that we are currently enjoying productivity acceleration does not ensure that equity prices are not overextended. There can be little doubt that if the nation's productivity growth has stepped up, the level of profits and their future potential would be elevated. That prospect has supported higher stock prices. The danger is that in these circumstances, an unwarranted, perhaps euphoric, extension of recent developments can drive equity prices to levels that are unsupportable even if risks in the future become relatively small. Such straying above fundamentals could create problems for our economy when the inevitable adjustment occurs. It is the job of economic policymakers to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.
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