In all the hubbub over Federal Reserve Chairman Alan Greenspan's remarks about productivity, stock prices, and the wealth effect, a crucial point in the outlook for the economy and interest rates is getting lost. The fact is, the New Economy requires higher interest rates.
It's not simply that economic growth, now refigured at a stunning 6.9% annual rate in the fourth quarter, is too fast. Or that the strong showings of consumer spending, confidence, and factory orders so far this quarter are raising the risk that robust demand will push inflation higher. The story goes deeper than that.
True, massive investments in productivity-enhancing technologies are fundamentally revaluing Corporate America. And stock-owning households are sharing in that wealth, which is helping to power the economy and create jobs, even for many who don't own stock.
However, the investment boom of the 1990s is also pressuring the capital markets to provide ever more financing for those investments. How do we know? Because for the past two years, the markets have been pushing up real interest rates, or rates adjusted for expected inflation.
Greenspan touched on this point, which went largely unnoticed, in his recent Humphrey-Hawkins testimony. He pointed out that the real rate on long-term BBB corporate bonds, which is a good proxy for the cost of credit in the corporate sector, has risen by a full percentage point during the past two years (chart). By definition, a rise in an interest rate already adjusted for inflation does not reflect inflation worries, and the increase began well before the Fed started to lift short-term rates. What it does reflect is "a quite natural consequence of the pressures of heavier demands for investment capital, driven by higher perceived returns associated with technological breakthroughs," he says.
STOCKS 101 tells us that a company's share price basically reflects two things: 1) the stream of expected net returns, or profits, that a company is projected to generate; and 2) an interest rate used to discount those returns for their riskiness and other factors. That combination yields the current value of a given company.
Part of Greenspan's argument is that investors' assessments of risk and other such discount factors, although having risen--as reflected in the higher BBB real rate--are still too low. He says, "to date, rising business earnings expectations and declining compensation for risk have more than offset the effects of this increase, propelling equity prices and the wealth effect higher." His implication is that real rates will most likely have to increase further.
It has been easy to speculate that stock prices are overvalued, based on traditional models that suggest--but don't prove--that price-earnings ratios are excessively high. But now, the rise in real rates is offering some stronger evidence: The uptrend indicates the markets' attempt to clear away a fundamental imbalance. Specifically, the Fed chief said it reflects an excess demand for funds to finance investment. What he did not say is that at least some of that excess demand is very likely showing up as inflated stock values.
THE KEY POINT HERE for the economy and Fed policy is the increasingly tighter link between the financial markets and real economic activity. Through the wealth effect, the excess demand for funds in the financial markets is mirrored by excess demand for goods and services, demand that the economy cannot satisfy without generating inflation.
In effect, the New Economy and its rapidly changing structure are demanding a rebalancing of both the financial markets and the markets for goods and services. Greenspan says that with the "assistance" of a tighter monetary policy, the financial markets will eventually lift real rates to levels that will restore that balance to both areas of the economy.
The big question is how much assistance will the Fed need to supply? Although much has been made of Greenspan's comments suggesting stock prices have to be reined in to limit the stimulus from the wealth effect, the Fed will continue to take its policy cues from the real economy, especially the labor markets. That's because, by addressing those imbalances, any financial market imbalances will get washed out as well.
The latest data suggest that the Fed still has much work to do to bring demand and supply back into equilibrium in the markets for goods and services. Although fourth-quarter economic growth was stunning, it was clearly exaggerated by a temporary surge in government spending and by some Y2K-related factors that boosted demand. However, even if overall gross domestic product growth slows to 4% this quarter, the yearly growth trend will speed up to 4.6%.
Two key sectors of demand are roaring ahead. The January level of real consumer spending, for example, already shows first-quarter outlays growing at an annual rate of 4.5% from the fourth-quarter average with February and March data still to come. Although consumer confidence dipped in February, in response to concerns over oil prices and interest rates, the decline was from January's record high (chart, page 29).
Also, capital goods orders and shipments, excluding aircraft, soared a respective 50% and 37% vs. their fourth-quarter levels, suggesting a sharp acceleration in first-quarter equipment outlays, after last quarter's pullback. And based on the February purchasing managers' report, industrial activity is picking up steam, and materials costs are rising (chart).
BUT IN THE NEW ECONOMY, problems for Fed policy go beyond the economy's powerful momentum. First, monetary policy is a blunt instrument that can rarely be wielded with much precision. Higher interest rates clearly threaten traditional businesses, such as cars and housing, more than they menace technology companies, who rely less on debt financing and whose products are less rate sensitive. However, it is the tech sector that is generating much of the wealth that continues to stoke demand for goods and services.
Second, because of the tighter link between the financial markets and overall demand, the Fed must maintain a heavy presence in coming months. As has become evident in recent years, any time Wall Street believes that the Fed is less inclined to lift rates, the markets rally, keeping the wealth effect alive, and stimulating spending.
The rise in real corporate rates is telling us that, if the Fed does not act to rebalance both the financial and product markets, market forces themselves will ultimately restore those equilibriums. Certainly, the Fed would prefer that the markets do some of the work of tightening financial conditions. But keep in mind that market reactions can be swift and volatile, especially in an era of uncertainty. That means in the uncharted waters of the New Economy, the Fed will likely steer a smoother course than the financial markets would.