Commentary: The Fed's Dangerous Liaison With Wall Street

Federal Reserve Chairman Alan Greenspan was just a rookie on the job a dozen years ago when he was confronted with his first crucial challenge: a stock market collapse on Oct. 19, 1987, that wiped 22.6% off the Dow Jones industrial average. Greenspan, who had joined the Fed two months earlier, responded exactly how the economic textbooks said he should. He flooded the banking system with money and drove down interest rates. Stock prices recovered and an economic downturn was postponed.

Now, the veteran central banker would like to execute a far more delicate maneuver in his ongoing dance with Wall Street. He wants to lead stock prices into a gentle landing before the supercharged market overheats the economy and stokes up inflation. But his ability to pull off that tricky step is hampered by the convoluted relationship that has grown up between the Fed and the stock market over the past 12 years. Each participant in this dance pays exceedingly close attention to what the other is doing--perhaps to the detriment of both.

SCARY SHADOWS. The Fed worries that stock prices are climbing too high but resists strong-arming its partner for fear that the market will overreact. "The Fed is too wrapped up in what the markets think," gripes David S. Gilmore, a partner at currency consultants Foreign Exchange Analytics. "It's as if they're making policy on the basis of CNBC broadcasts."

The market, meantime, plays the role of the insecure ingenue. At bottom, it knows the Fed will provide a strong shoulder to lean on in a downdraft. Still, there are scary shadows in the economy, so the market hangs on the central bank's every word for reassurance and reacts violently when it feels that approval is withheld and interest rates head higher.

This dance could become downright dangerous if the Fed becomes paralyzed by fears of hurting the stock market and holds off from hiking rates--even when tightening is needed to keep inflation in check and the economic engine in balance. Also, investors are in danger of becoming too confident that the Fed will bail them out in case of a crash--so they can proceed to bid up prices to unrealistically high levels. Economists call such a development moral hazard. Investors take on more risk than they believe is reasonable because they're convinced they won't have to face any consequences.

Some Wall Street experts, pointing to today's lofty price-earnings ratios, fear that this is already happening. "There's an expectation in the market that any time that stock prices decline significantly, the Fed will ease monetary policy and reverse the decline," says veteran Wall Street analyst Henry Kaufman.

In a way, Greenspan is a victim of his own success. His ability to rescue the market in 1987 and again last fall--when the Fed cut rates three times in rapid succession and helped arrange the bailout of hedge fund Long-Term Capital Management--has given him godlike status. Investors twitch at his every comment. But playing God is a hard role to sustain, especially when you're really not infallible.

That's why the Fed is reviewing how best to communicate its leanings on interest rates to the markets. Greenspan has even created a panel to study the question after it became clear in recent weeks that its present method just wasn't working.

Former Fed Vice-Chair Alice M. Rivlin says investors are always trying to second-guess the central bank. "People have the notion that the Fed has a clear idea of what it's going to do next, and it just isn't telling," says Rivlin, now at the Brookings Institution, a Washington-based think tank. "That's simply not true." But then again, Greenspan is also trying to anticipate the markets.

Maybe the answer is that both sides should stop obsessing about each other. They--and the U.S. economy--may be the better for it.