Fed Wizardry May not Conjure up the Desired Economic Effects

January 17, 2001

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.

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