Don't Fight the Fed

I am a believer in investment maxims. If there weren't some truth to them, they would either work their way out of the financial lingo, or their stubborn adherents would work their way out of their finance jobs. Among those maxims, the one that graces the top of this page is a particularly convincing one. While the Fed's powers may be vastly overrated by the media and members of the financial community, the one area where it has undisputed capability is in its ability to lower equity values by raising short-term interest rates.

Of course, in the past, the Fed wasn't particularly interested in lowering equity values. The Fed concerned itself with the value of the dollar, the stability of the currency, the rate of inflation, and the macroeconomic outlook. Classic Fed policy was to "take away the punch bowl" when the economy overheated, or to provide liquidity to a strained banking system. The impact on equity values was a byproduct of this activity, the occasional severity of market volatility in reaction to Fed moves notwithstanding. But we have a different type of Fed these days, one that believes its own press, I fear; and, in fairness, a different situation than the ones that have confronted most Fed chairmen in the past.

Role Reversal

First, the latter. The decade of the 1990s has seen an unprecedented growth of interest and participation in the financial markets. This growth has been accompanied with an explosion in equity values. The combination of these two trends has escalated the economic importance of stock market wealth to such an extent that the market is no longer a mere reflection of underlying economic trends. Instead it has become an important, perhaps dominant, factor in the economy. While this is hardly news, it nonetheless presents the Fed chairman with a new set of challenges. Specifically, the health of the market is a crucial variable that the Fed must consider in making policy. There was a time, and not so long ago, when policy makers could ignore stock market gyrations. The old saw that the stock market had predicted ten out of the last six recessions meant that bear markets were financial phenomena, not economic ones. No longer. This Chairman appears to believe, and I agree, that there are profound economic implications to stock market moves. Perhaps not since the 1920s has this been true, but the evidence for it today seems overwhelming. Because of this, the Fed Chairman has focused on the market like no chairman in my memory. Ever since the now famous "irrational exuberance" speech, Greenspan has been worrying about the market and its potential for destabilizing the economy.

Equity prices have blithely ignored Greenspan's warnings and continued to climb to ever-higher record levels. In a generally well-balanced economy showing no signs of inflation, only the stock market has exhibited the kind of excess that typically leads to an economy-jolting reversal. In previous cycles, housing or commercial real estate was responsible for bursting the bubble.