Why the Fed Can't Ignore the Market

It is certainly true that the Federal Reserve has no business managing the stock market per se. Its basic concern is the health of the economy. Still, it is equally true that the stock market's impact on the economy has increased significantly over the past five years. Not only has it financed venture-capital investments in new high-tech companies but it also has come to play a central role in family finances. Some 50% to 60% of Americans have a direct stake in the market, far higher than in previous downturns. Individuals and families personally manage their retirement funds, their children's education funds, and their personal savings via the stock market. The wealth effect of these investments plays an enormous role in consumer spending patterns and economic growth, much more than in the past. Just as expanding equity wealth spurred spending and growth on the upside of the current business cycle, shrinking wealth is now pushing growth lower. It may be that stocks, especially high-tech stocks, have a ways to go before price-earnings ratios return to the sane zone. In the end, though, there can be no real economic recovery without a market upturn. The Fed can't manage policy to please the market, but it can't ignore the market, either. The wealth effect is too mighty (page 38).

Take the Nasdaq. Since 1996, when the New Economy began to lift off, nearly every bounce in consumer spending has been accompanied by a bounce in the Nasdaq. In the past, there has usually been a lag in the wealth effect. When stock markets shifted, consumers took six months to a year to change their behavior. Recently when the Nasdaq dropped, the growth rate of consumer spending dropped. When the Nasdaq rose, the growth rate of consumer spending increased. The immense decline in the Nasdaq since March of last year has been followed by a sharp decline in the growth rate of consumer spending. Unless the Nasdaq recovers, the growth rate in spending is likely to fall much further.

The danger is that the power of a negative wealth effect is being underestimated by policymakers. For the first time in 55 years, household net worth fell last year, according to the Federal Reserve. The culprit? Falling stock prices led to declining values for household portfolios. Households lost nearly 2% of their net worth in 2000. Many families are also discovering that they must pay hefty taxes on capital-gains distribution by mutual funds, even though the funds themselves were mostly down for the year. If the markets don't recover anytime soon, households could begin to cut spending even further to strengthen balance sheets. There are increasing signs of deleveraging and cash accumulation in the economy. This bodes ill for prospects of economic recovery in the second half of the year. It should induce policymakers to lean toward ease and take out recession insurance.

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