Will Fed Move Fast if Market Gets Gored?
07-15-00 | 05:54 AM by Pierre Belec | NEW YORK (Reuters) - To the delight of Wall Street's bears, Federal Reserve Chairman Alan Greenspan has finally been confirmed as the nation's chief investment strategist. The bulls, though, are snorting mad.
The bears have given the central banker's performance a good review. He's taken some of the air out of the stock market bubble by raising interest rates six times over just 12 months to keep the economy's fast growth from reigniting inflation.
But what if Greenspan errs and drives the stock market over the cliff, all for the sake of slowing down the economy? Also, would the central bank be able to turn on the retro rockets at the right time to avoid a hard landing of the economy, if the stock market free falls?
One expert says the Fed, which meets Aug. 22 to map out its next move on interest rates, may not be able to do much to offset the economic fallout from a market crash.
Ray C. Fair, professor of economics at Yale University in New Haven, Conn., said the Fed is dealing with the most delicate market scenario in history, and for that reason, Greenspan may be powerless to pull the stock market out of a head-spinning fall.
The reason: Too much ``souffle'' -- or ``wealth effect'' -- has been baked into this market.
``One big difference is that prices in today's stocks are much higher relative to earnings than they were during the speculative frenzy that led to market crashes in 1929 and 1987,'' he said. ``In this sense, there is more risk of a crash independent of Fed policy now than earlier.''
The Street has another reason to worry. The Fed will not scrap its tough anti-inflation campaign and force itself to learn to live with inflation so as to avoid raising interest rates too much and possibly creating a market crash.
``If inflation picks up a lot, it seems likely that the Fed would raise rates a lot more, even if this meant a large fall in stock prices,'' Fair said. ``I can't see the Fed letting inflation rip just to prevent stock prices from falling.''
Sounds like scary stuff.
``The negative effects from the loss of stock market wealth following a crash would dominate the positive effects from the Fed lowering interest rates immediately after the crash,'' said Fair.
The bottom line would be a ``significant'' recession, Fair wrote in a paper titled, ``Fed Policy and the Effects of a Stock Market Crash on the Economy.''
Using a macroeconometric model, he painted a picture of a market crash causing a severe negative impact on consumer confidence and spending, with Greenspan desperately rushing to rescue Wall Street by cutting interest rates to undo the damage from an overly aggressive money tightening.
Fair's crash case: A 50 percent meltdown in the Standard & Poor's index to 700 points, which would throw the market back to its 1995 level. The S&P currently hovers at 1,495.
Such a nosebleed drop would wipe out some $6.5 trillion in U.S. market wealth, sending the economy slamming head first into recession. The scenario assumes the crash is sustained and stocks fail to react to a swift move by the Fed to cut interest rates to 3 percent from 6.5 percent.
A jolting bear market would bring the first structural change in investors' expectations since 1995, when single-digit gains were the norm for stocks, Fair said.
From 1996 to 1999, the market posted out-sized gains of 20 percent or more each year as stocks became the nation's lottery game of choice.
The string of extraordinary returns appears to have been broken this year, suggesting that stocks may be flipping back to the norm due to the Fed's credit tightening.
In the first half of the year, the Dow Jones industrial average was off 9.1 percent and the Nasdaq composite fell 2.5 percent while the Standard & Poor's slipped 1 percent.
But the price/earnings multiples of the S&P are still above the norm at 35, compared with the historical average of 15, which was the rule in 1995, Fair said.
``If the P/E ever came back down to the area where it used to be, then it would represent a drop of about 50 percent in the S&P index,'' he said. ``So my scenario is that, if the P/E returns to the historical level, and the Fed can't get it to go back up again, then we would get a big recession.''
This year's market slide has put a damper on the wealth effect, which Greenspan has blamed for spurring Americans to go on a spending spree, buying tons of stuff because their fat stock portfolios have made them ``feel'' rich.
But experts say stocks have not fallen far enough to cause people to have nightmares over loss of wealth. And, the market's downturn has merely shaken the economy, causing only a modest slowdown.
In Greenspan's view, the uncontrolled wealth effect is bad because wild excesses can lead to shortages of goods that could drive up prices and put the economy in an inflation spiral.
The wealth effect, as measured by the Wilshire 5000 index (.TMW) of most U.S. stocks, has shrunk to $14.08 trillion from a high of $14.75 trillion in the first quarter.
Wall Street has always romanticized the notion that once the Fed's credit squeeze becomes too painful, Greenspan will come to the rescue of the market to keep the economy out of recession.
Twice before Greenspan has pulled magic tricks, in 1987 as stocks crashed, and again in 1998 when the global economic crisis threatened to drag down the U.S. economy.
After the 1987 stock crash, the Fed reassured Wall Street that it was there to keep the flow of cash going amid the crisis and in 1998, the central bank cut interest rates. Both moves helped to send stocks into a recovery. ''But cutting away at interest rates may not be the panacea that will save the stock market from free fall this time around,'' said Ned Riley, chief investment strategist at State Street Global Advisors in Boston.
``There are precedents in Japan,'' he said. ``As the Japanese central bank burst the bubble in stocks and real estate a decade ago with higher interest rates, it tightened too long and wound up hurting the confidence of the average investor.''
Indeed, memories of Japan may be haunting Greenspan.
``Even with today's low interest rates in Japan, the economy is still struggling to get back on its feet,'' Riley said. ``The Fed has this lingering hangover of Japan, but it knows that if the U.S. thing runs too rampant, too many people are going to get hurt, not only from a jobs perspective but from a speculative market perspective.''
Perhaps the best thing that Greenspan did in 1987 and 1998 was to reassure nervous investors that the central bank was willing to build a firewall around the stock market and protect their investment portfolios against big losses.
Greenspan's speedy action in heading off domestic market crises also turned him into a ``Fed Superman'' -- making the chairman the super hero of Wall Street. The 'S' on his red suit might stand for ``STOCKS.''
Only time will tell if the Fed's anti-inflation strategy, which is supposed to extend the nation's economic growth and make the stock market more rational, turns out to be a sad reminder for investors that there are no sure things on Wall Street.
For the week, the Dow Jones industrial average was up 176.77 points at 10,812.75. The Nasdaq composite index jumped 222.84 to 4,246.04 and the Standard & Poor's 500 index was up 31.05 at 1,509.95. Reut06:53 07-15-00 |
