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.