Fed Brief
Updated: 14-Jan-00
Policy Overview
It wasn't exactly Atlas Shrugged, but the January 13 Greenspan speech was classic Greenspan.
There were plenty of hands (on the one hand...), but there was also a message.
The message was that the equity price increases similar to those seen in recent years cannot
continue.
We have been among those who have argued that Greenspan does not target equity prices. While
that is still literally true in that Greenspan does not have specific levels of equity prices in mind as
he sets policy, it is no longer true in spirit.
For all of the talk of technological revolution, the Internet, productivity growth, and an expansion that
is "profoundly different," there was ultimately a well-constructed chain of reasoning that led
Greenspan to the conclusion that equity prices must be contained.
It Starts With The Pool
Greenspan's primary obsession is the pool of available workers which, as he is fond of reminding
us, is shrinking. No one would argue that this trend could continue forever, as you cannot have a
negative number of available workers. Fair enough.
And while we have more than 9 mln to go before we get to zero, Greenspan has run out of patience
and wants to see the pool stop shrinking now. The question then is how. Naturally, he offers the
answer, albeit in an indirect fashion.
Having assumed that the pool of workers must stop shrinking, Greenspan turns to the discussion of
how it will stop. His answer:
"What will stop the wealth-induced excess of demand over productivity-expanded
supply is largely developments in financial markets."
The chain of reasoning continues -- to stop the wealth-induced excess of demand:
"For the equity wealth effect to be contained, either expected future earnings must
decline, or the discount factor applied to those earnings must rise."
Here we have the statement of intent: contain the equity wealth effect. And we have the means to
do so: since the Fed cannot directly control expected future earnings, the discount factor as the
only option for containment. The discount factor, in English, is the long term real interest rate. It has
already risen over a full percentage point due to increased demand for investment capital and "a
central bank intent on defusing the imbalances that would undermine the expansion."
The final question is how long the central bank will be defusing the imbalances before it achieves its
goal. Naturally, Greenspan has the answer to that as well:
"A diminution of the wealth effect, I should add, does not mean that prices of assets
cannot keep rising, only that they rise no more than income."
For the equity bulls in the audience, Greenspan at least holds out the olive branch of rising equity
prices. But he also draws the line: prices of assets cannot rise more than income.
That, fellow Fedwatchers, is the endgame.
For someone who has said in the past that he does not target equity prices, this sure looks like
hairsplitting. Greenspan travels from his declaration that the pool of available workers must stop
shrinking to how it can be accomplished, and lo and behold, it's by targetting equity price gains
equal to income. It's not a target level, but it is a target growth range.
And for the record, income -- unlike the Nasdaq -- has not been growing 80% per year. It's more like
6%.
Forecasting Psychology
Economists are always armed with a forecast of how much the Fed will ultimately have to raise
rates -- 50 bp, 75 bp, etc. But here's an admission: we have no idea how far they will go.
If this were about economics, we would argue that 2-3 more quarter point rate hikes would probably
do it. But the Fed has equity market goals in mind, and the equity market is driven more by
psychology than economics right now.
Another quarter point rate hike on February 2 appears to be a near certainty. But beyond that, who
knows? It could be that the equity market cools off with just one more hike, or perhaps it will rally
another 25% and the Fed will hike three more times after that.
If forced to guess, two more rates hikes should probably do it for awhile, but this is only a guess.
Just as this economic expansion is "profoundly different," so to is this Fed tightening cycle.
Fedwatchers will be watching the stock market for clues, and stock market participants had better
be watching the Fed.
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