James Strauss, not so fast: Economy is in " Catch - 22 " situation:
Catch-22
By Irwin Kellner
6/23/00 3:23 PM ET
dismal.com
The more the stock market celebrates what appears to be a slowdown in economic growth,
the less likely it is that the economy will, indeed, slow.
The sooner the economy rebounds, the greater the chances are that the Federal Reserve
will continue to tighten money and raise interest rates.
And the more interest rates go up, the less likely the possibility that both stocks
and the U.S. economy will be able to maintain their record-setting upward climb
, leaving the stock market little to celebrate, in the final analysis.
If there were a way to convince the markets to tone down their exuberance today
so that they might have something to cheer about tomorrow,
this chain of events would not have to occur.
Unfortunately there is not.
In today's atmosphere, no one wants to be the first to leave the party
--but no one wants to be the last one out the door, either.
That's why the Federal Reserve has begun the process of tightening money and raising interest rates.
It hopes to moderate some of the exuberance that has permeated the financial markets these past few years,
with the hope of avoiding a collapse in prices altogether.
These are the economic facts of life, and they are nothing new.
Back in the 1950s, for example, then-Fed Chairman William McChesney Martin,
when asked to explain the role of the central bank to a much less-sophisticated public,
was fond of saying that the job of the Fed was to take away the punch bowl before the party got too exciting.
It was known as far back as the 1950s that the stock market had a major influence
on the economy--even though relatively few people were active investors.
A study conducted jointly by the Federal Reserve Board and the
Massachusetts Institute of Technology led to the development
of what came to be known as the FRB-MIT econometric model.
It showed that the stock market was the channel through which monetary policy
affected the economy. It did this by altering people's perceptions of their wealth and confidence.
Obviously, those who were in the market felt wealthier when stocks would rise,
and poorer when stocks would fall--even if they had not actually realized their gains or losses by selling.
So a major change in the market's direction would invariably lead to a similar change
in people's spending patterns, although not necessarily to the same extent.
In other words, if the stock market were to fall, consumers might spend a bit less
on big-ticket durable goods while maintaining, if not increasing, their expenditures
on smaller-ticket soft goods and services.
The chart below shows the relationship between stock prices and consumer spending in recent years.
dismal.com
Of course, since relatively few people invested or traded stocks,
the far greater effect was on people's confidence.
When the stock market boomed, for example,
it usually made headlines, or was the lead story on the evening news.
The average person no doubt felt that if the people whose
livelihood depended on making
an accurate assessment of the business outlook were
confident enough to bid up stock prices,
then it was OK to go out and make a major purchase, such as
a car or a house.
Jobs, it was felt, would be secure so that these items
could be afforded.
When the Fed wanted to slow the economy down,
it would tighten money and raise interest rates.
This would cause stocks to lose their luster, and as the
market retreated,
spending would slow, thereby achieving the Fed's objective.
To be sure, this is not as simple a process as it appears.
Many times, the Fed would overdo its tightness, causing the economy to lapse into a downturn.
That's one reason why the United States has sustained nine recessions since
the end of the Second World War, and a total of 16 downturns of varying severity
since the Fed was created in 1914.
Having twice asserted that tighter money and higher interest rates are bad for stocks,
it now behooves me to elaborate. Higher interest rates hurt stocks for a number of reasons.
First of all, they cut into corporate profits.
Interest rates are a cost of doing business, just like
labor, rent and materials,
so when they go up, they cause business expenses to rise.
All things equal, this will reduce corporate earnings.
In addition, higher interest rates can reduce business sales by making
it more difficult for people (or companies) to borrow in order to buy the goods
that business produces. As corporate profits decline, stocks usually fall as well,
in order to maintain their proper valuations relative to other uses of investors' capital.
This brings up a third reason why higher interest rates are bad for equities,
and that is the attractiveness of the main alternative for most investors--bonds.
When the Fed tightens money, not only do short-term interest rates rise,
but long-term rates go up as well. This makes bonds more attractive than stocks.
The reason is that higher bond interest rates offer a better payout than stocks,
whose dividend yields are usually declining because of falling profits,
and whose prices may be declining as well. Bonds, unlike stocks,
can be held to maturity, thus protecting investors from falling prices.
Finally, higher interest rates make it more difficult for people to buy stocks on
margin--even if the Fed doesn't increase margin requirements.
This reduces the demand for equities even further, thereby pushing down their prices.
The relationship between monetary policy and the stock market shows up clearly in the chart below.
dismal.com
It stands to reason that the outlook for the stock market will be determined by how much tighter
monetary policy becomes. This, it seems to me, will hinge on how much economic growth
reacts to the increases in interest rates and the declines in stock prices that have already occurred.
It will also depend on just how much the Fed wants the economy to slow from its current pace.
If one wants precision (a risky proposition, to say the least),
one could calculate the economy's ideal rate of growth nowadays.
That would seem to be based on growth in the labor force (about 1 percent per year)
plus the increase in labor productivity in the non-farm business sector
(around 3 percent per year), for a total of 4 percent, after adjusting for inflation.
There are two problems with this calculation, however.
First, the Fed, judging by the speeches of its chairman, Alan Greenspan,
and other officials, has not yet accepted that productivity is, indeed, growing this rapidly.
They might agree that productivity is rising faster than 2 percent per year,
which is the average of the past 10 years, but not as much as 3 percent,
which covers only 1999. So in the Fed's eyes, the economy's sustainable growth rate
comes out to somewhat less than 4 percent.
The second concern is that the Fed might want to slow growth below its ideal
or sustainable rate of growth in order to generate enough slack to moderate
what it believes are incipient inflation pressures. This is because economic growth
has exceeded its presumed speed limit for the past three quarters,
averaging more than 6 percent over this period.
To cool things off, the Fed might well want the economy to grow at a subnormal rate
for at least the rest of this year. If this is the case, with the economy still expanding
close to 4 percent per year, it would seem to suggest that the Fed is not yet through
raising interest rates. In turn, this would
not seem to augur well for equities--at least over the next few months.
What it means for the economy in general remains to be seen.
As I observed earlier, the Federal Reserve has had a history of overdoing things,
when it comes to monetary tightness. (The same might be said for monetary
ease--in other words, letting the economy race ahead until inflation pressures bubble up.)
Another well-known metaphor to describe Fed policy is that it is analogous to driving a car
with a loose steering wheel. Let's hope Alan Greenspan pulls in for a pit stop before it's too late.
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Message #55236 from James Strauss at Jun 25, 2000 2:34 PM ET
The Fed knows that once the process takes hold, it doesn't reverse in one month's, or even a few months', time. Policy-makers also know that the rate increases administered to date affect the economy with a lag.
Just the way Greenspan used his intuition when he let the economy cruise full speed ahead, he is going to have to tap those talents again to decide when he's done throttling back.
Good article Tunica...
The effects of those 6 rate hikes plus the stabilization of oil prices should start showing up in future CPI readings... I believe that Greenspan and Co. understands full well, that "lag" effect, and will stop the rate hikes at or immediately after this Tuesday's meeting... Otherwise they would be piling on to the last two or three hikes that have yet to weigh on the economy... It would put the next president in an Economic Box as budget surpluses start to dwindle... I don't think Greenspan would want to start off on the wrong foot with a new president...
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