January 17, 2001: Spotlight
Fed wizardry may not conjure up the desired economic effects
Mr. Greenspan, how exactly does a soft landing transpire in our current environment?
By Brady Willett and Todd Alway
Easy Al needs no introduction and neither does his polished, whether intentional or not, ability to
entice investors into believing that he is the savior of the stock markets. Throughout Greenspan's
tenure 'avoiding potential problems' is what he has done best, and the average investor clearly knows
this by now. They know this because the media spills out endless, and more often than not, bullish
rhetorical innuendo surrounding the Fed. After all, two weeks ago the Fed cut interest rates by 50
basis points and the Nasdaq crashed higher by 14%. What more proof is needed?
But what the average ticker chaser does not know is that economic circumstances can and do
change, and that what has worked in the past may not work in the future. Ironically, stunned bears
figured this out the hard way in the 1990s as high stock market valuations rose even higher, and
stocks like Coke became status rather than ticker symbols. Waiting for the markets to crash in the
1990s was not a profitable pastime. Despite the statistical indicators, investor perception in the
1990s remained Bullish until the end. Getting back to the Fed, the point is that unless investor
perceptions regarding monetary policy are congruent with the Fed's stated goals, the markets and
the economy in general may not behave as expected. The only thing monetary policy can definitively
change is the rate of interest on monies leant – it does not necessarily produce the expected effects
on the economy as a whole. One need only look at the situation in Japan over the past decade for
the proof of this statement. Using history as guide is one thing, but using it as a crystal ball for the
markets it is quite another.
To begin with, the United States economy will soon be in a recession. Forget what you know or
think you know regarding the statistical anomalies concerning this issue. Simply understand that the
Fed slashed interest rates between meetings by 50 basis points for the first time in a decade
primarily in response to a crash in consumer confidence; a crash brought about by a snowballing
downtrend in both equity prices and the prospects for growth in the U.S. Understand also that as
Stephen Roach, Lester Thurow, George Soros, and many others begin to prophesize a recessionary
environment this prophesy will more than likely become a self-fulfilling one. The lesson is that as
more people begin to foresee a recession, behavior will be modified in such a way that the trickle of
negative economic data will produce a torrent of consumer restraint.
Furthermore, becoming bearish on the economy can spur an adage worthy of attention; once you go
bearish you never go back. Think about it this way; if the statistical indicators on debt, savings and
credit quality, are deemed to be sufficiently negative to convince an analyst that a recession is
indeed in the cards, in what way could a loosening of credit by the Federal Reserve change that
conclusion. Would any easy money policy not further aggravate these measures? Case in point,
Harvard bred economist, and former Federal Reserve Board governor Lawrence Lindsey: He had been
warning of an economic crunch for much of the 1990s – claiming that consumers were spending
beyond their means, that the nation was too dependant on foreign lending, and that the equity
markets were wildly overvalued. Would a decrease in the lending rate change this opinion? In this
regard, how can the growing pessimism over the economic outlook become significantly optimistic
until a recession ultimately arrives, correcting the economic imbalances? Can the markets rally
inside of this mind state?
The converse perspective to the recessionary case argues that the economic statistics should be
given less favor than the remarkable history of Greenspan's interventions; doomsayers prophesizing a
1990s depression after the stock market crash in 1987 were wrong, and similar outlooks in 1994/95
and 1997/1998 also turned out to be incorrect. Greenspan is heralded as the doctor that stitched up
the wounds during those periods of history. Never before, not even with Volcker, have so many been
entranced by what they consider to be Fed 'genius'. Again, self-fulfillment plays a role.
Nevertheless, what this isolated look at Fed history can end up doing is building a framework of
fallacy: the misguided belief that the markets have been following Greenspan to begin with. In fact,
an objective look at market behavior does not portray investor harmony with the Fed. Take the
simple notion of 'don't fight the Fed', a popular adage backing most non-recessionary premises
today. Its premise is that as the Fed starts cutting interest rates one should not bet against stocks,
and vise versa. But what this notion does not factor in is that the markets have been fighting the Fed
tooth and nail since 1996. The most recent battle shows the Fed beginning to raise interest rates on
June 30, 1999 – by the time Greenspan was finished raising interest rates the markets had just
capped off their most fantastic rally ever.
Even today, both markets remain near their marks of June 30, 1999, when the Fed started to raise
rates. Consequently, Fed activity should only be interpreted in the context of an already existent
bearish or bullish sentiment.
Yes, when Greenspan starts cutting stocks typically start rising. However, this time around the Fed
might have waited just long enough to stem this conjunctural occurrence. The investing public is
becoming less fascinated with interest rates, and more concerned with corporate fundamentals:
corporate earnings, global growth projections, the negative savings rate, and the degradation of credit
quality in America. Can any amount of rate cuts immediately mediate the expected defaults in the
corporate arena? No. In fact, if the Fed is overanxious in cutting rates the quality of debt could
further deteriorate. These additional loans would exacerbate the credit crunch if the soft landing is
only temporarily engineered. Will earnings immediately be impacted dramatically to the upside
because businesses are allowed to borrow at .50% less than on January 2? No. Whether the
Federal funds sits at 6% or 4% means little if confidence does not mirror the move. Perhaps
ironically, a severe recession may be necessary in order to correct the economic imbalances and
restore consumer confidence.
In sum, it is no longer the case that profit-making in the equity markets is a sure thing, that corporate
growth will accelerate forever, or that the GDP is capable of sustaining a 5% growth rate for the next
decade (contrary to what Fed McTeer had been speculating). The dreary statistical evidence of a
slow-down has made investing in stocks more dangerous, even as prices become cheaper. When
the Fed was unable to prompt a sustained change in investor attitudes by cutting rates on January
3rd , this generated further concern and disbelief among investors and consumers. Now, confidence is
all that holds the economy away from recession, and the Fed is likely to keep cutting interest rates
until it hits a nerve – when the systemic response from America will take place is anyone's guess.
Not even Greenspan can sculpt confidence as effectively as the lending rate.