Stocks' Rally Wakens Fed Diviners of Inflation
By E.S. BROWNING
Staff Reporter of THE WALL STREET JOURNAL
One thing is sure about the huge stock rally that capped trading last week: Alan Greenspan didn't like it.
The Federal Reserve chairman has been worrying lately that the stock market itself could fuel inflation if its gains make consumers more eager to spend money. Twice already, in June and August, the Fed's worries about incipient inflation in the economy made it boost guideline interest rates. Now, if the chairman is as worried about stocks as he sounds, the markets could be in for more unpleasant Fed efforts to keep a lid on stock and bond prices.
If the Fed wants to hold stocks down, notes Ned Riley, chief investment officer at BankBoston, "The best strategy that they can pursue is to continue to create anxiety in the market." He worries that stock indexes could have trouble advancing much this year.
And if the Fed's goal was to confuse the markets, it certainly succeeded last week. Markets were closed Monday for the Labor Day holiday. But following news of moderate August wage increases, the Dow Jones Industrial Average on Friday soared 235.24 points, or 2.17%, to 11078.45. That marked its second-largest point gain of the year and fifth largest in percentage terms. The Nasdaq Composite Index, heavy in technology stocks, rocketed 108.87, or 3.98%, its largest point gain to date and 12th-largest thus far in percentage terms.
But anxiety about a possible third Fed rate raise in October had driven stocks sharply down in the days before. Even after the industrials' big gain on Friday, their earlier declines left them down 11.72, or 0.11%, for the week.
Investors had hoped that the Fed's Aug. 24 rate increase would put an end to the issue, but that hasn't happened. Now all eyes are fixed on the Fed's next meeting, at the start of October. Before then, investors will bite their nails over Friday's announcement of producer-price data for August, and the announcement of August consumer-price information the following Wednesday.
The debate on Wall Street is whether the Fed will content itself with two rate raises, those of June and August, or go for a third. Mr. Riley, for one, thinks that Fed officials will avoid further increases, but that they will do their best to talk tough in an effort to keep investors off balance and rates up.
"They would love to talk the market down," says Christine Callies, chief U.S. market strategist at Credit Suisse First Boston. But, she adds, "that usually hasn't worked; in fact, I can't remember a single time it has worked in the past 200 years."
There are plenty of bulls who think that, despite all the talk, market interest rates are close to their high points now, unlikely to get much worse. That is the view of Goldman Sachs investment strategist Abby Joseph Cohen, for one.
"We have seen most of interest-rate excitement for this year," says Ms. Cohen, who believes that the stock market continues to benefit from the Fed's success at fostering moderate economic growth with low inflation.
"It is possible, but by no means certain that Fed will raise rates again later this year, but even if they do, it already is reflected in long-term bond yields," Ms. Cohen says. In other words, market rates already have moved up so much in anticipation of a possible rate increase that they aren't likely to move much higher.
She expects a combination of strong corporate profits and favorable inflation and interest-rate news to push stocks higher in the second half of this year. "We believe that inflation troughed last year, but won't be moving dramatically higher soon," she says.
Some analysts add that, even if the Fed wants to raise rates later this year, it will hold back. Why? The economy may need loose credit and plenty of liquidity at year end, in case jitters over year-2000 computer problems cause people to pull money out of investments.
"We are rapidly approaching a point where the Fed's primary job will be to provide liquidity for those who wish to hold cash for the start of the year 2000," maintains Prudential Securities chief investment strategist Greg Smith in a report to clients.
Some Fed officials insist that they won't let the year-2000 effect tie their hands.
And Gary Campbell, chief investment officer at Commerce Funds, in St. Louis, thinks the Fed will surprise the bulls by carrying out its veiled threats.
"We think it is quite possible that the Fed is going to do it" -- raise its interest-rate guideline -- "again before the end of the year," he says. "Ultimately, they will act." What's more, he adds, "those higher rates will jeopardize current levels of the stock market, and potentially give us a correction," or a decline in stock prices of about 10%.
Given the recent increase in unit labor costs, an inflation indicator the Fed watches closely, the year could wind up looking something like 1994, he says. The Fed's repeated rate increases that year kept the stock market from going anywhere, making it the worst year for stocks since 1990.
"What we saw in 1994 was a preemptive Fed doing its work," he says. "And I don't think the Fed is going to be any different in terms of a strong economy going from 1999 into 2000."
Some analysts think the Fed planned all along to reverse all three of the rate cuts that it ordered last fall, when it wanted to help end the world financial crisis spurred by Russia's debt default. An October rate raise would reverse the last of last year's three quarter-point cuts.
Ms. Callies sees a debate growing between those who see a strong economy and higher interest rates, and those who see what has been called a Goldilocks economy, with moderate growth, light inflation and no rate increases. She worries that the debate could drag on, putting a lid on stock gains for the rest of the year.
"Very often when the markets get stuck in these trade-offs, it takes several months to resolve the issue," she says.
Stocks certainly have had trouble making progress since talk of a Fed rate raise began in April.
In the past two weeks alone, stocks soared around the time of the Aug. 24 rate increase, in hopes that the Fed was done raising rates. Then Mr. Greenspan made his veiled comments about the risk that stock gains themselves could cause inflation, and stocks plummeted. That slide continued amid reports of higher manufacturing costs, and comments from Fed Governor Edward Kelley that the Fed might not be done raising rates. Then came Friday, when a report of moderate August wage gains made stocks turn on a dime and head up again.
Keep your seat belts fastened. |
