Haunting Parallels - 1927 and 1998
by Paul Kasriel
Wednesday, March 17, 1999
In 1927, the Fed eased monetary policy for two reasons. First, the economy was experiencing a mild recession. In large part, this recession was
not cyclical in nature. Rather, the slowdown in economic activity that started late in 1926 was exacerbated by the closure of Ford plants for
several months in the spring of 1927 to switch production from Model Ts to Model As. The second reason the Fed eased was for international
reasons. The UK was experiencing a gold outflow. With the U.K. economy already weak and suffering from deflation, an increase in British
interest rates to staunch the gold outflow would have conflicted with domestic policy objectives. So, New York Fed President Benjamin Strong,
who fancied himself as an "internationalist," agreed to lobby the Fed policy board to cut U.S. interest rates in order to reduce the gold outflow
from the U.K. to the U.S. Although there was a conflict between domestic and international policy goals in U.K., for the most part, the two
goals were compatible in the U.S. I say "for the most part" because there was one element that argued against a Fed easing in 1927 - stock
market mania. A broad common stock price index calculated by Standard and Poor's increased at a compound annual rate of 16.7% from May
1924 through May 1927. What's more, starting in 1925, there was a marked pickup in loans collateralized by securities. One Fed Board
member, Adolph Miller, dissented from the majority decision to ease policy because he thought that such easing would add to, what he
considered, the speculative excesses in the stock market. He was correct. From May 1927 to May 1928, this aforementioned S&P stock price
index rose 33.2%, with loans collateralized by securities rising 44.4%. By late January 1928, the Fed had reversed course and was starting to
raise interest rates, which it continued to do into 1929. You know what happened to stock prices in the fourth quarter of 1929.
Fast forward to late September 1998. The U.S. economy was showing signs of weakening. Second quarter GDP growth slowed to 1.8% from
5.5% in the first quarter. The Purchasing Managers' Index was consistently below 50. Retail sales were flagging. And the September increase in
nonfarm payrolls, released in early October, was originally reported as up only 69,000. The midyear General Motors strike played a large role
in the weak second quarter GDP growth and in some subsequent weak economic data. But with the turmoil in the rest of the world, it was
difficult to disentangle the GM- strike effects from the negative foreign trade effects. The stock market had fallen by 19% between July 17 and
August 31, credit spreads had widened with a vengeance, the Russian financial markets had collapsed and Brazil was teetering even as Japan
remained mired in recession. Because inflation was hardly visible, as was the case in 1927, the Fed started cutting the funds rate on September
29. By the close of business November 17, the funds rate target was 75 basis points lower than what it was on September 28. And how did the
stock market respond to the Fed easing? At the closing bell on December 31, the S&P 500 was 17% above its September 28 close and 28%
above its August 31 close. I'll leave it up to you to decide whether the Fed's late 1998 rate cuts sparked a speculative runup in stock prices.
Will the Fed raise rates in 1999 to curb the stock market advance as it did in 1928? It is not inconceivable that the Fed would raise rates this
year, but it would have to have some different rationale than just reining in the stock market. The marble halls of the Fed building in D.C. are
haunted by the ghost of 1928. The Fed is not likely to make that mistake again. But what if the recent increase in oil prices sticks? What
happens if Japan is successful in reflating its economy? Then U.S. inflation would likely start moving higher. Under these circumstances, the Fed
would have to raise rates or forfeit its credibility as the defender of stable prices. You know what happened in late 1929. I wonder what will
happen in late 1999?
Household Asset Holdings Have A Riskier Profile These Days.
Despite the fact that households were net sellers of stocks in 1998, their holdings of equities at market value increased by about $60 bln. or by
about 20%. If households were net sellers of stocks, how could the value of their holdings increase? Because of the increase in the price of
stocks. As the chart below shows, equities now represent 25.0% of total household assets - a postwar high. Deposits, including shares in
money market mutual funds, are 9.5% of household assets - the lowest in the postwar period. One big difference between stocks and deposits
is that normally, deposits are redeemable at par. The redemption value of stocks is unknown ahead of time. Let's just assume, for the sake of
argument, that the Dow moves to 7500 before it hits its fair value, which, according to an op-ed piece in the Wednesday Wall Street Journal, is
36,000. Households are going to suffer a big wealth decline given that stocks currently bulk so large in their asset portfolios. Back in 1986, the
year before the October crash, stocks were only 10.5% of households' assets and deposits were 14.8%. So, households had more of a wealth
"cushion" just before the 1987 stock market downdraft. Given how much economic growth now depends on household spending and given how
much household spending depends on the stock market, the economic growth is now very vulnerable to a major stock market setback.
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