By Pierre Belec
NEW YORK(Reuters) - Federal Reserve Chairman Alan Greenspan may give new meaning to the expression ``FED UP'' as he raises interest rates until more of the wealth effect is squeezed out of the economy and stock market.
After 10 months and five interest-rate increases, a frustrated Greenspan is discovering that the ``new economy'' is an entirely new ballgame and it's tougher to get the same mileage as in years past
from rate increases.
The economy is still in great shape and people are still borrowing to buy stuff, even though some $2 trillion in stock market wealth has been destroyed by the Fed's tough money policy.
While stocks have pulled back from their highs, the bull market has not been brought to its knees. An example: The battered Nasdaq
composite index this week still managed to rack up its second-biggest daily point gain ever, a stunning 228-point rise on Tuesday.
Now, the Street is facing a sixth interest-rate rise from the central bank's policy-setting meeting on May 16, which would further drive up the cost of credit card and mortgage loans. And, it may not be the last boost.
Why?
``In the last three major tightening cycles -- 1984, 1988 and 1994 -- the Fed has engineered a slowdown in economic activity only after the fed funds rate rose to a level equal to, if not above, the growth in nominal
GDP,'' says Warburg Dillon Read.
With the Gross Domestic Product expected to jump 7 percent year on year this summer, according to some estimates, the central bank may need to jack up the fed funds rate, or the rate charged for overnight
bank lending, to 7 percent by year-end, up sharply from today's rate of 6 percent.
The Fed has in the past considered 3.5 percent a safe,
non-inflationary rate of growth for the GDP.
This week, the government reported that consumer spending was up a whopping 8.3 percent in the first quarter -- the biggest rise in nearly nine years -- with the spending binge expanding the gross domestic product, or GDP, at a 5.4 percent annual rate after a torrid 7.3 percent
gain in the fourth quarter last year.
Another impressive number was the price gauge, a measure of personal consumption expenditure, which rose at a 3.2 percent annual rate in the first quarter -- the steepest increase since 3.5 percent in the third quarter of 1994 and up sharply from 2.5 percent in the final quarter last year.
The GDP would have shown a much larger increase, had it not been for a drop in inventory accumulation by companies that had built them up strongly at the end of last year due to Y2K jitters.
Wages also rose at the fastest pace in more than 10 years in the first quarter.
So, if history holds true, then Wall Streeters should put on their crash helmets and prepare for a Fed bombing raid in the coming months.
Greenspan credits the booming stock market for making a lot of people ``feel'' rich and turning them into shop-aholics.
The wealth effect has kept central bankers awake at night because they fear that this four-year joyride in stocks is on a collision course with inflation.
Roughly put, the Fed views the wealth effect as a threat when people have big paper profits from stock investments and, feeling rich, they buy a garage-full of Porsches. This surge in demand can cause shortages of all sorts of things, which eventually drives up prices of goods, fueling inflation.
Real estate, for example, has gotten a huge lift from the wealth effect. The cost of buying a home has gone through the roof as cash-rich buyers have been willing to pay up, at times by raiding their stock portfolios. Even the entry-level buyers have tapped their 401(k) pensions to cover down payments, betting that the ``forever'' rising
stock market will rebuild their mutual funds before retirement age.
Greenspan is on record as saying he is not gunning for stocks, but, instead, aiming for the wealth effect that the market generates. The reality is that it's one and the same.
What's worrisome is that people are piling up loans and the Fed-led boost in lending rates is adding a lot of weight to these debts, creating an even more dangerous situation.
The Fed chairman is scratching his head, wondering why the volley of interest-rate increases hasn't done the trick.
One reason is that the new economy has changed the way
businesses operate. Most companies are not as dependent on
short-term debt as they used to be.
For another, investors are no longer easily dissuaded by monetary tightening. They've gotten drunk on four consecutive years of big profits from stocks and the Fed would need to resort to shock treatment to get their attention.
Silence of the Fed?
The interest-rate story is also no longer scary for Wall Street because of the Fed's openness. The new and nicer Fed politely signals its intention to change interest rates, which has robbed it of the surprise
element that had worked effectively under other central bank regimes.
Wall Street is now betting the central bankers will raise by another tiny quarter percentage point each in May and June. The shape of the economy in the final quarter will then form the Fed's policy.
What sort of risks does the stock market face?
Greenspan could scrap his gradualistic approach and come up with an attention-getting half-point rate hike.
Another risk is that a falling market may not have as good of a safety net this time around.
Unlike in the 1987 market meltdown and the 1998 global economic crisis, Greenspan may not rush to help stop a freefall in stocks. The reason: A knee-jerk decision to loosen up the money supply, i.e., flood
the system with cash, could reinflate the stock market bubble.
``If recent market plunges and volatility were likely to make the Fed less aggressive (with its money policy), we'd be less concerned,'' said
Richard Salsman, chief market strategist for InterMarket Forecasting Inc. ``But Fed officials have been relatively indifferent to the recent carnage -- and dismiss it as normal. That's bad news.''
How many more trillions of dollars in lost market wealth would satisfy
Greenspan?
God only knows.
``By now, considerable damage has been done,'' said Salsman, a long-time critic of Greenspan. ``Will it get worse? Based on its bogus belief that excessive growth and employment gains cause inflation, the Fed is likely to keep raising rates -- at least three more times this
year.''
There is no question that the stock market is a huge source of wealth.
Household net worth climbed last year at the fastest pace in history, thanks to the boom in stocks. Household worth shot up $4.7 trillion to $42.3 trillion in 1999, with 75 percent of the gain generated by exploding financial assets.
``Americans' net worth is weighed heavily toward the stock market,' says Steve Rhode, president of Myvesta.org, formerly known as Debt Counselors of America, a nonprofit group that gives people advice on handling their debt loads.
``The robust economy and heady gains in the stock markets are giving people a false sense of security about their ability to handle debt,'' he said.
Indeed, the Fed reports that most of the growth of family wealth between 1989 and 1998 was generated by profits from stocks, mutual funds and tax-deferred retirement accounts. These investment vehicles, which accounted for 48.4 percent of Americans' assets in 1989, zoomed to 71.3 percent by 1998. Stock ownership jumped from
31.6 percent in 1989 to 48.8 percent in 1998.
``Add the higher risk of the stock market to people's high
debt-to-income ratio and we have a recipe for trouble,'' Rhode said. ``If the economy stumbles, many people will find themselves with debt problems.''
For the week, the Dow Jones industrial average was off 110.14 points at 10,733.91. The Nasdaq composite index rose 216.78 at 3,860.66 and the Standard & Poor's 500 index was up 7.89 at 1,452.43.
(Questions or comments can be addressed to
Pierre.Belec(at)Reuters.Com). |
