The Risks In Fed Policy

On Mar. 21, the Federal Reserve will meet and almost certainly raise U.S. interest rates for the fifth time in a year. The goal is to slow down economic growth, now racing ahead at a 6% annual rate. But the specific target is the stock market, which is said by the Fed to be the source of excessive wealth and demand in America. Perhaps it is. And certainly there is a case that 6% growth exceeds even the New Economy speed limit. But the Fed strategy carries a very big risk. By raising rates it can easily bring the Old Economy to its knees without doing much to prick whatever bubble exists in New Economy stocks.

Truth is, the overall indices hide the damage already done. Only two sectors in the Standard & Poor's 500-stock index are up year to date--technology, of course, and utilities, thanks to a flight to safety. Equity prices in communication services, health care, energy, capital goods, transportation, consumer goods, financials, consumer cyclicals, and basic materials are all down, some by double digits. Even the broadest measure of stock market performance, the Wilshire 5000, is off 1.5% so far in 2000.

The four previous rounds of rate hikes have succeeded in knocking down practically all Old Economy stocks, including blue chips such as Gillette Co. and Warren E. Buffett's Berkshire Hathaway Inc. Take out a handful of the big-cap technology stocks and the average price-earnings ratio for the vast majority of stocks in the S&P 500 is down to 20 or less, hardly overvalued. Which means that even as growth has accelerated in recent quarters, overall equity wealth has been declining, and sharply.

Paradoxically, one consequence of the drop in the broad market has been a rush by investors into a tiny handful of tech stocks, pushing them ever higher. Momentum, not value, now rules in the markets. In January, a record $40.5 billion went into capital-appreciation stock funds. That compares with $12 billion in January of last year. A quick look inside the portfolios of these aggressive growth, growth, and sector funds shows that they focus on the same high-tech and biotech stocks.

In essence, the bubble that the Federal Reserve has repeatedly warned against is being nurtured by the Fed's own policy of targeting stocks and wealth. The fragility of the market increases with every passing day. It is an altogether unsettling picture.

And unnecessary. There are powerful forces already in motion that are sure to slow the economy. Higher mortgage rates are curbing the housing boom. Gas prices that will probably hit $2 a gallon by the summer are sure to crimp consumer buying power. Perhaps most important, there has been an almost perfect match between swings in retail sales and the stock market over the past four years. When the Wilshire shot up 20% last year, retail sales jumped 15%. The Wilshire is now flat to falling, and odds are that retail sales will follow. Simply put, with inflation showing just a few signs of creeping up, there is no urgency and no reason to risk crushing the longest expansion in U.S. history.

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