Does Alan Greenspan watch CNBC?
Wednesday, August 14, 2002
globeinvestor.com
Whenever the U.S. Federal Reserve Board meets to set its target for interest rates - as it did on Tuesday - the major markets hold their collective breath. After all, investors both large and small hang on every word that falls from Fed chairman Alan Greenspan's lips, and the widespread perception is that the central bank makes its decisions on interest rates with a keen eye on what the stock markets are doing. But does it? And should it? That continues to be the subject of considerable debate.
If you watch business news channels and read the comments made about the Fed and Mr. Greenspan - known in some circles as The Maestro - it's easy to come to the conclusion that regulating the stock market is the Fed chairman's number one job. When the Nasdaq was soaring, many market-watchers were calling for the Fed to take action to burst the stock 'bubble' that was forming, and now that markets are 40 or 50 per cent lower than they were, the cries are for action by Mr. Greenspan to boost stock prices.
An older generation of economists no doubt finds this attitude totally wrong-headed. In the past, the job of a central bank was twofold: to adjust the money supply and interest rates in order to keep a lid on inflation while at the same time encouraging investment and supporting the dollar, and to ensure the integrity of the banking system. What the markets did was seen largely as noise - save perhaps for extreme events such as the Crash of 1929, when the market's fall became a threat to the economy.
That view has changed, however, and not just because business writers began to put the Fed chairman on a pedestal, to the point where some analysts tried to predict the direction rates would take based on the size of Mr. Greenspan's briefcase as he headed into the Fed meeting. The average person's relationship to the stock market has also changed over the years, as the number of people investing has increased dramatically.
The theory is that this creates a 'wealth effect' - meaning when stocks are high, people spend more. The conventional wisdom is that every dollar in market wealth leads to three or four cents in spending. As markets have plummeted, however, the focus has switched to the opposite: If stocks collapse, will consumers spend less? The 'poverty effect' has been blamed for Japan's decade-long slump, and it's part of the reason Morgan Stanley economist Steven Roach is predicting a 'double-dip' recession.
Some economists have argued that the wealth effect is largely a myth, and that the No. 1 factor behind consumer spending is income - meaning as long as someone has a job, they are likely to spend even if their stock portfolio has gone south. The value of one's house has far more to do with spending than stocks, they argue. Others believe that consumers increasingly base their spending decisions on their expectation of future income, and that stock values are a big part of that estimate.
Mr. Greenspan has made comments over the years that show he believes the stock market plays more of a role in the economy. In 1999, he said: "As the value of assets and liabilities have risen relative to income, we have been confronted with the potential for our economies to exhibit larger and perhaps more abrupt responses to changes in factors affecting the balance sheets of households." He added that central banks "No longer have the luxury to look primarily to the flow of goods and services ... when evaluating the macroeconomic environment in which monetary policy must function."
That doesn't mean the Fed is supposed to try and control the market like a giant puppeteer, mind you. Mr. Greenspan told Congress in 2000 that "We are not focusing monetary policy on the stock market. We are focusing on the economy. To the extent that the stock market affects the economy, we respond to that." If, for example, fears about the health of company balance sheets puts a damper on consumer and/or corporate spending.
The risk in paying too much attention to the rise and fall of stock prices, some warn - and the reason the Fed chairman is so careful about his comments - is that seeing Mr. Greenspan as the markets' pied piper can create a 'moral hazard.' That is, investors might decide to take unreasonable risks because they believe the Fed will help them out if the market tanks. Of course, the fact that markets have gone steadily downward after 11 successive rate cuts makes that hazard seem less likely.
Nevertheless, the Fed's comment on Tuesday that the economy remains at risk because of "weakness in financial markets" means Mr. Greenspan is keeping an eye peeled for further declines. Just don't expect him to help you sell those Nortel shares you bought at $110. |
