A few days back I wrote a piece on why I think the wealth effect has become understated because it is based on outdated studies of its magnitude:
Message 13838746
My suggestion at the time was that the Fed will agonize over raising rates but ultimately should decide not to because the Naz crash and the previous rate cuts have probably already done the trick (with an assist from gas prices, as Dawg and others have pointed out).
Yesterday I ran across the following article, quoting a Fed publication (my comments follow the article):
biz.yahoo.com
Monday June 12, 1:41 pm Eastern Time
Cleveland Fed sees weak stock price-inflation link
WASHINGTON, June 12 (Reuters) - There is little evidence to support the notion that a run-up in stock prices can cause inflation in the U.S. economy, the Federal Reserve Bank of Cleveland said in its June ``Economic Trends'' publication.
Some economists believe a surge in stock prices makes investors feel wealthy and causes them to spend more freely, which can boost demand past available supply, causing inflation.
But Cleveland Fed researchers said this month that history shows little data to support such a link between stock prices and inflation.
``Evidence that the stock market causes inflation is weak at best,'' the researchers said.
``There is little discernible correlation between CPI inflation and the S&P 500 growth rate,'' the researchers said, referring to the Labour Department's Consumer Price Index and Standard and Poor's stock index (^SPX - news).
In fact, the researchers said stock market prices have an effect on inflation in only a ``minority'' of countries.
Broad U.S. stock indices are up slightly from June 30, 1999, when the Federal Reserve raised interest rates for the first time in its latest campaign to head off inflation. The tech-heavy NASDAQ is up nearly two-thirds from a year ago.
The Fed has raised interest rates six times in the last year.
Federal Reserve Chairman Alan Greenspan and other Fed officials have insisted they are not out to deflate U.S. stock values but have said that they are keeping a close eye on the markets and their potential impact on consumer demand.
Regarding recent data that have shown a slowdown in the U.S. economy, the researchers said analysts need to be careful in reading too much into one month's data, which are often revised later, or can be skewed by weather patterns or unusual holiday schedules, which has been the case this year.
``It often takes several quarters of data to bring fundamental patterns into focus,'' they said, noting that analysis of data is often distorted by preconceived notions by economists, investors and policymakers.
``Despite every effort to adjust officially reported statistics for these potentially distorting factors, history shows that analysis -- and policymakers -- have made incorrect inferences and decisions as a result of blurred vision,'' the researchers said.
For example, the researchers noted that the May unemployment figures released by the government earlier this month could support the argument that the U.S. economy is slowing down but could also boost claims that the economy continues to grow at a strong pace.
The researchers noted that the total number of U.S. jobs rose 231,000 last month, which could support the view that the economy continues to expand at a rapid pace despite the rise in the unemployment rate in May to 4.1 percent from 3.9 percent in April, taken by many in the markets as a sign the U.S. economy is weakening.
They said proponents of the view the economy is slowing would focus on the fact that temporary Census workers accounted for 357,000 jobs in May and private sector employment actually dropped 116,000.
END OF ARTICLE ---------------------
I think that anyone relying on studies of what happened in the past in the U.S. and other countries to support an argument that there is no significant "wealth effect" is engaging in seriously flawed analysis. The U.S. of the late 90's experienced a confluence of events which were unprecedented in the history of capitalism: (1) a huge surge in stock ownership by individuals (not just wealthy individuals but middle and upper-middle class individuals who are the engine of consumer spending); (2) the Internet caused stock trading to become instantly accessible to the masses at extremely low prices; (3) the public (or at least those millions who participated) showed an almost unbelievable appetite for technology stocks such as those included in the Nasdaq composite and Nasdaq 100 indexes, moreso than the broader S&P 500; (4) the indexes of stocks the individual investor was favoring surged nearly 100 percent in a year, wiping out all records for increases by a large index in a developed country's equity market.
The major point that the Fed is missing, IMO, is that the relationship between equity prices and spending is not linear. It is not particularly logical to conclude that if a 10 percent increase in stock prices leads to a 0.1 percent increase in consumer spending, then a 20 percent stock price increase will lead to a 0.2 percent spending increase, a 30 percent stock increase will lead to a 0.3 percent spending increase, and so on. Rather, at the margins, where you have a particularly large increase or decrease in equity prices, it is perfectly reasonable to expect a far more pronounced impact on consumer spending. It could be that an 80 percent increase in equity prices causes a large impact on consumer spending even though a 10 percent increase in equity prices produces no discernible impact. This is particularly the case when you have a larger segment of the public participating in investing activities and favoring the portion of the equity market which is the most volatile.
The important point is that such an effect would likely operate in both directions. A 40 percent decrease in equity prices (which is the equivalent to a 67 percent increase) should, according to my theory, cause a marked decline in discretionary consumer spending. Combined with relentless Fed rate increases, it is like driving a car with both feet on the brakes.
The Fed article posted above suggests that nobody is paying attention to this possibility. I think, though, that Alan Greenspan is an extremely intelligent and astute economist. I realize he is not particularly popular around these parts right now, but there is no denying that the man is an intellectual force on the Fed. I believe that he recognizes the fallacy in relying on old wealth effect studies to conclude that the market's effect on consumer spending can be largely ignored. I believe that he understands how the relationship between stock prices and spending can appear to be a linear function at lower levels when it is actually a logarithmic function, and therefore much more pronounced when extended out to higher levels of stock price fluctuation.
And I believe that he will lobby hard at the June Fed meeting to wait and see rather than raise rates yet again. His view may not prevail, but even if it doesn't, I believe that the at-most 25 basis point increase we might see in June will be the last one for awhile.
And if it is, the current dip down in the Naz, when it bottoms, may be the last really good buying opportunity of this cycle.
MAD DOG |
