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The Fed did the right thing

Marie-Josée Kravis

U.S. Federal Reserve Chairman Alan Greenspan gave Wall Street a surprise party on Wednesday—the Nasdaq posted its fourth biggest gain since 1971, and the Dow its third largest gain ever. It is too early, however, to uncork the champagne. The Fed confirmed that it had broadened its surveillance of the U.S. economy to include issues beyond price stability and market liquidity, but it also has made it perfectly clear that it will not be steered by narrow stock market considerations.

The Fed was adamant that it not appear to be targeting the stock market for fear of creating a moral hazard bail-out precedent and, appropriately, its actions came as a complete surprise following some recent, albeit modest, improvements in the Dow Jones and the Nasdaq. The market had probably priced in a 50-basis-point interest cut expected in May, but it had all but concluded that inter-meeting intervention would not occur. For the pessimists, the Fed action confirmed their worse, fears: The Fed knew something ominous.

The stunning Fed statement did contain some references to the effects of the stock market decline, to the slowing world economy and to eroding business confidence, but its focus on the problems of the real economy contained no unexpected revelations and revealed nothing that many cost-slashing CEOs had not already stated.

The Fed message was mixed, as are numerous economic signals. On the positive side, the Fed stressed progress made in reducing excess inventories, the steady course of housing and consumer expenditures and the positive outlook for productivity. The list of concerns is slightly more worrisome. The Fed is clearly uneasy about growing signs of an impending investment crunch which would dampen productivity and output growth. Capital investment has been weakening markedly, and profit warnings suggest a deterioration in business performance and confidence. The Fed statement was unambiguous: ‘The potential restraint, together with the possible effects of earlier reductions in equity wealth on consumption and the risk of slower growth abroad threatens to keep the pace of economic activity unacceptably weak.’ The Fed was targeting the real economy, not the stock market, but it was also acknowledging the growing influence of the market on the real economy.

It is now estimated that 50% to 60% of Americans have a direct stake in the stock market given the tremendous growth of personal retirement accounts, education funds and mutual fund holdings. Interestingly, the trend in consumer sentiment matches the Nasdaq curve almost perfectly. The sharp decline in the Nasdaq since last year has triggered not only a decline in consumer sentiment, but also a drop in consumer spending which accounts for two-thirds of U.S. GDP. This ‘unwealth effect’ is a new feature in the U.S. economy, and a key factor in the decline in household net worth last year—the first such fall in 55 years. In the context of repeated announcements of layoffs and cost-cutting by corporations in all sectors, it was not surprising that the Fed would feel the need to restore some confidence in the future. In fact, many CEOs have been predicting that the second half of 2001 would be more problematic than the first half, and the Fed may have wanted to assuage those fears and break the psychology of recession. As the statement pointed out ‘against the background of its long-term goals of price stability and sustainable economic growth and the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.’

In other words, things look quiet on the inflation front, but recession may be looming. In fact, key financial and commodity indicators suggest deflation and continue to point to a shortage of liquidity in the U.S. markets. Gold prices have been dropping after a brief uptick and the commodity futures index has been slipping. The short end of the Treasury curve remains inverted while the long end of the yield curve has dropped thirty basis points. Market rates have been falling more rapidly than Fed rates, causing analysts to blame the Fed for being behind the curve and prompting banks to withhold liquidity. Though the credit crunch appeared to have eased in recent weeks, financial signals did suggest an urgent need for Fed easing.

The Fed did the right thing, and it was clever to inject some surprise into financial markets, catching a host of short-sellers in punishing situations. After an eighteen-month period during which it raised rates 150 basis points, it has effected a 200-basis-point reduction in four months. This is bound to buoy economic activity, but its effects on the market are less certain, at least in the short term. Adjustments in the real economy have just begun. Corporations will continue to cut costs and inventories, and will announce more layoffs. Large excesses and imbalances developed during the Goldilocks days of market euphoria and Y2K fears. Business investment, especially in technology and telecommunications, as well as hiring, surpassed needs and reflected anticipation of future growth or disruptions that never materialized. Corporations have not completely rid themselves of this excessive fat, and the earnings picture is unlikely to improve rapidly. Moreover, the European economy is slowing as the European Central Bank watches on and Japan remains stagnant. There is no high-powered engine to sustain a rapid acceleration in world demand.

This is all the more reason to be thankful that the Fed has at last acknowledged the prevailing weakness. Hopefully there will be more to come in May.

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