U.S.: The New Ingredient In The Fed's Mix
The stock market is not a target of Fed policy. Federal Reserve Board Chairman Alan Greenspan said just that--twice, in fact--in his Jan. 20 congressional testimony. "Our objective," he said, "is maximum sustainable growth of the U.S. economy, not particular levels of asset prices." But there's a problem. Because economic growth and stock prices are now connected unlike at any time since the Roaring '20s, any Fed move directed at either preserving or limiting growth will be magnified by the stock market's reaction.
The economy's surprisingly strong growth at yearend and consumer-led momentum heading into 1999 illustrate that link. The Fed eased last fall because unstable global markets had disrupted financing activity in U.S. debt markets. "We were not trying to prop up equity prices," Greenspan told Congress. Yet that's just what they did--so much so that consumer spending, after slowing a bit in the fall quarter, skyrocketed back toward its 6% growth rate of the first half of 1998, as confidence stayed high (chart).
It's no one-quarter phenomenon, either. Over the course of last year, consumer spending rose about two percentage points faster than household income did, mainly because surging stock prices let many households stop saving. Consider that, in the past six years, household net worth swelled nearly 50%, even as the measured saving rate fell below zero. Had the saving rate over the past two years held at the historically skimpy 3% rate of 1996 instead, real gross domestic product growth would have been about 2.7%, not 3.7%.
HOUSEHOLDS' INCREASED RELIANCE on wealth, not income growth, means that while the Fed does not "target" stock prices, it cannot set policy without anticipating how stock swings will affect domestic demand and overall economic growth. That presents a particularly thorny problem for 1999 policy because GDP growth has become unusually skewed toward consumers, the biggest beneficiaries of the wealth effect.
Last year, for example, consumers accounted for some 90% of overall economic growth. And that unbalanced pattern may worsen in 1999, since capital spending, housing, and exports are likely to provide less support to growth this year than they did in 1998. Consequently, the stock market's path could result in anything from recession to continued booming growth.
Consumers will determine which outcome occurs. For now, they remain optimistic. The index of consumer confidence, though down from last summer's 30-year peak, edged up to 127.6 in January from 126.7 in December, undoubtedly buoyed by healthy job growth. But a bit of caution has crept into households' attitudes about the future, even as their assessment of present conditions has stayed historically high.
The renewed surge in equity prices likely boosted the current heady viewpoint, but the stock market's role here goes beyond just the bull market's feel-good factor. Because of the wealth effect, consumer demand is boosting overall output--and employment--at a pace far greater than what income growth alone would allow. In a sense, the soaring market has helped to generate the job opportunities that have lifted consumers' spirits. However, Greenspan cautioned about the cost pressures from ever-tighter labor markets. And he noted that somewhat slower economic growth may be needed to sustain this low-inflation expansion.
MORE MODERATE GROWTH will likely be found in the sectors outside of consumer spending. In particular, housing, capital spending, and exports will face their own singular restraints in 1999.
The case for housing is simple: Trees don't grow to the sky, and neither do home sales or construction. Housing finished a record 1998 on a strong note, though good weather helped. In December, existing homes sold at a record annual rate of 5.03 million. But a repeat of growth like that would require another big decline in mortgage rates, continued robust job growth, and an additional 30% jump in stock prices.
As for capital spending, the outlook is poor, regardless of the stock market. Profits are under pressure from weak pricing power, higher labor costs, and sagging exports. That is creating a growing lack of internally generated funds and forcing corporations to borrow at a time when funds are costlier or unavailable.
The risk spreads that attracted attention after the Russian debt default last summer have not improved much, even for borrowers with a sterling AAA rating (chart, page 31). The yield spread between riskless Treasury bonds and the paper of BAA-rated companies, which is still investment-grade, has not improved at all. Moreover, Fed surveys show that banks have tightened their corporate-lending standards.
THE ONE SPREAD that is almost back to normal is the gap between a new 30-year Treasury bond and a 29-year Treasury, which is less liquid. After Russia, this "on the run/off the run" spread widened as the debt markets seized up and investors sought not just quality but liquidity, provoking the Fed's rate cuts.
Although the spread has narrowed, it is still worth watching in light of Brazil's woes. The Brazilian real has crashed 36% in two weeks, after the government freed the currency from its peg to the dollar. But worries that Brazil could default on its huge domestic debts are mounting. If those fears turn into a panic, then the flight to liquidity and quality will make capital much more costly for businesses, which, in turn, will likely put more of their projects on hold.
Brazil's woes also highlight the dim outlook for foreign trade. The trade deficit widened sharply in November, to $15.5 billion, after narrowing to $13.6 billion in October. November exports slumped, as imports rose. Renewed weakness in exports was predestined: Foreign shipments had picked up sharply in September because of a large increase in aircraft shipments. In fact, aircraft exports helped to give the impression that the trade gap was stabilizing, but excluding planes, the deterioration continues (chart).
The fact that the U.S. remains an oasis of prosperity assures continued deterioration in its trade deficit, as imports grow amid weak foreign demand. Brazil and key Latin American nations are heading into recession. Japan is already there. The rest of Asia is stabilizing but still on its back. Britain is flirting with recession, and growth in Europe's euro zone looks to be slipping below its '98 pace.
All this means that consumers have a heavy load to carry, and the stock market will go a long way toward deciding if households are up to the task. Equally important, the market is creating a whole new ballgame for monetary policy: The Fed must achieve "maximum sustainable growth" without creating a dangerous stock market bubble or knocking equity values down to levels that would harm the economy.
To continue reading this article you must be a Bloomberg Professional Service Subscriber.
If you believe that you may have received this message in error please let us know.