Stocks a puzzle for Greenspan
'Asset inflation' looms, but few remedies available
By Kimberly Blanton, Globe Staff, 07/06/99
lan Greenspan, who has calmly navigated the nation's economy through the longest peacetime expansion in history, may be losing his cool.
The chairman of the Federal Reserve Board has expressed in his public remarks a growing frustration with a stock market that just won't quit.
His fear, Fed watchers say, is that stock prices have become so high that this ''asset inflation'' - an increase in the value of individuals' portfolios, including stocks, mutual funds, and homes - may pose a bigger threat to the economy than old-fashioned price inflation, which has not reared its head.
If stocks fall, consumers would feel poorer and would stop spending, causing the economy to slow dramatically. In the worst case, the stock market is increasingly looking to some economists like a bubble that could pop, wreaking havoc on the financial system and the economy.
''Greenspan's nervous about it,'' said Karl Case, professor of economics at Wellesley College, but he ''doesn't know what to do about it.''
The Fed's rocky relationship with the stock market came into focus last Wednesday after the Federal Open Market Committee, which sets interest-rate policy, voted to nudge the federal funds rate up a quarter percentage point to try to slow an economy that barrels along, creating an estimated 268,000 jobs last month.
While the FOMC's modest rate hike was widely anticipated on Wall Street, its surprise decision to withdraw its bias toward raising rates further in coming months sent the Dow Jones industrial average soaring beyond the 11,000-point milestone to an all-time high.
''What we do not need is for the stock market to go higher, which adds to the wealth effect, which adds to the growth in the economy,'' said Nicholas Perna, chief economist for Fleet Financial Group Inc. The Fed action, he said, was ''bizarre.''
Since the FOMC announcement, the Dow has gained 324 points, and closed Friday at 11,139.24.
While Fed actions clearly can influence stocks, managing the market is not part of Greenspan's mandate, which is to keep inflation at bay.
''Leaving aside the notion of some sort of crash, which would threaten to make financial markets fragile, their interest in the stock market is mostly indirect,'' said Benjamin M. Friedman, an economics professor at Harvard University.
That may be true, but Greenspan's remarks about the stock market have appeared with increased frequency and intensity.
The Fed chairman first broached the problems the stock market poses for FOMC members in December 1996. He grabbed headlines by using the term ''irrational exuberance'' to describe the market. The Dow at that time was around 6500.
This year, he has become preoccupied with stocks in his testimony.
In January, speaking to the House Ways and Means Committee, he said gains earned in the stock market have created a ''wealth effect.'' Translation: Consumers feel rich, confidence has soared to levels unseen since 1968, and they are driving the economy for a 100-month expansion. The Fed estimated that the stock market contributed an estimated 1 percentage point to the growth in the gross domestic product over the last three years.
In a June 17 speech before the Joint Economic Committee of Congress, Greenspan said stocks have reached ''unsustainable levels.''
Despite this concern, Fed members are not inclined to do anything about bloated asset prices, Greenspan said, adding that ''monetary policy is best primarily focused on stability of'' prices. He concluded by virtually admitting the Fed is helpless to do much about the stock frenzy: ''It is useful to preempt forces of imbalance before they threaten economic stability,'' the chairman said. ''But this may not always be possible - the future at times can be too
opaque to penetrate.''
Pointing to Greenspan's testimony, veteran Fed watcher David Jones of Aubrey Lanston & Co. in New York said he believes that Greenspan ''is more worried than anything else about the wealth effect of a runaway stock market.''
Jones added, ''It's a concern because it means the economy is growing faster rather than slower at a time the Fed wants to slow it down. The Fed could lose control.''
One reason is that asset-price inflation is relatively uncharted terrain for traditional economists - including economists at the Fed.
Fed members ''don't have any sure way to say [stocks are] overvalued or undervalued - unlike traditional inflation models, where you do have a way of determining that,'' said Lawrence Horwitz, managing director of Primary Decision Economics in Boston.
But Wellesley College's Case said it is possible to determine how much wealth is being created by higher asset values.
Take rising housing prices in the Boston area. Based on repeat sales of houses, Boston housing prices rose 10 percent for the year ended February 1999. That one-year gain created about $1.4 billion in wealth in the Boston area alone. ''I'm convinced that a lot of the prosperity we're experiencing right now is a result of asset inflation,'' Case said.
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