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Why Greenspan Won't Let Up

Economic Trends

Why Greenspan Won't Let Up

Goldman sees a series of increases

After the recent bloodbath in the stock market, the economy should cool off in a hurry, right? Not according to economists at Goldman, Sachs & Co. They argue that since stock prices remain higher than they were for most of last year, consumers still feel a wealth effect that will keep them spending. They say the Federal Reserve will have to raise interest rates a lot more to slow the economy. Before you write them off, take note: In a speech on Apr. 12, Federal Reserve Governor Laurence H. Meyer pointed to Goldman's Financial Conditions Index as evidence that recent monetary policy actions have had "a smaller effect than usual--nearly zero--on overall financial conditions and hence on aggregate demand."

The Fed has already raised the fed funds rate five times since last June. But Goldman Sachs argues that the fed funds rate doesn't fully indicate financial conditions. Its index is made up of short-term bank rates, corporate bond yields, the dollar's exchange rate, and the stock market. The four components of the index are the inflation-adjusted rate on three-month interbank loans, known as LIBOR; the inflation-adjusted yield on single-A-rated corporate bonds; the inflation-adjusted, trade-weighted exchange rate value of the dollar; and the ratio of U.S. equity-market capitalization to gross domestic product.

After the Apr. 14 stock market rout, the Goldman index stood at about 97, barely above the 96.64 level of last June, when the Fed first began raising rates. (Lower numbers mean easier conditions.) Goldman Sachs chief economist William C. Dudley acknowledges that the index doesn't take into account the psychological impact on customers of a sudden, sharp drop in stock prices. But, says Dudley: "A temporary dip in stock prices is not a big deal." And he said Goldman Sachs strategist Abby Joseph Cohen is expecting the Standard & Poor's 500-stock index to rise 20% from its Apr. 14 level over the next year. If so, the wealth effect will remain a problem for the Fed.

Concludes Dudley: "The Fed will have to do more than people anticipate, and short-term rates will have to stay higher longer than people expect." He expects the federal funds rate to rise from its current level of 6% to above 7% sometime next year.By Laura CohnReturn to top

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The Fed Speaks, but Who Listens?

Openness doesn't influence investors

Since 1994, the Federal Reserve has become more open about its policy decisions. Instead of staying mum on days that the Federal Open Market Committee meets--leaving investors to rely on changes in the level of bank reserves to alert them to policy changes--Fed policymakers began to announce their decisions. At times, especially recently, central bankers have even explained the reasons for their decisions.

Market mavens and journalists praised the central bank for its openness. So has this big shift made a difference to the stock market? Not really. According to a new study by economists Antulio N. Bomfim and Vincent R. Reinhart of the Federal Reserve, "there is no evidence that the new disclosure policies of the post-1994 period significantly changed the way asset prices respond to monetary policy."

The researchers looked at the volatility of various asset prices on the days of unanticipated Fed actions. They found that the volatility was about the same in the pre-1994 period as in 1994 and after. The Fed's change did not seem to reduce market uncertainty about the future of interest rates.

Why no change? The authors of the study, "Making News: Financial Market Effects of Federal Reserve Disclosure Practices," offer two hypotheses. Either the Fed's silence before '94 was "overstated" or the shift toward greater openness was too slight to have a big impact on the markets. In other words, they say, it could be that the press releases that followed Fed meetings weren't "specific enough to shape market opinion in any consistent manner."By Laura CohnReturn to top

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