Alan Greenspan always insisted that, under his leadership, the Fed never
targeted stock values. However, it's hard to interpret some of his actions
any other way.
New Fed chairman Ben Bernanke was thought to be of even sterner stuff in
keeping the Fed to its most important role of maintaining general price
stability. However, it's hard to interpret the Fed's most recent moves as
anything other than targeting stock values.
In 1996, Greenspan famously referred to "irrational exuberance" in stock
values. The market took a cautionary stumble after his public scolding, but
only momentarily. Stock values soon started climbing rapidly again.
In less than a year beginning in mid-1999, the Fed raised the federal fund
rate from 4.75 percent to 6.5 percent. This was supposedly to ward off
inflationary pressures from the so-called "wealth effect," the claimed
tendency of people to spend more because the value of their assets real
estate and stocks had increased.
At no time just before or during this period did the Fed's preferred
inflation measure rise above 2 percent. Despite his protests to the
contrary, Greenspan was pretty clearly trying to wring what he regarded as
irrational exuberance out of asset values.
Greenspan seemed to believe that there was value in the public perception
that there was someone in charge of the U.S. economy, namely him. In
contrast, Bernanke appeared committed to a more transparent, modest role.
Then the subprime mortgage market began to drain.
While some of the details of the subprime mortgage market difficulties are
complex, the overall economic problem is easy to state and understand.
There has been an overinvestment in housing. That overinvestment has to
work itself out of the economy.
This won't be an easy or smooth process. Markets always overreact. That's
part of their self-correcting mechanism, as overreaction by some begets
opportunity for others.
Lenders have overreacted to the problems in the subprime mortgage market,
becoming generally skittish rather than selectively so. A lot of the
economy runs on short-term debt, which has become hard to come by.
This is not really a liquidity problem. There's still plenty of capital
around. It's just reluctant to deploy. Hence much of it is being parked in
safe treasuries, whose yields have sharply decreased.
This is not a situation the Fed can or should do much about. Money isn't
going to stay parked in short-term, low-yielding treasuries for long. Over
time, and probably not over much time, lenders will sort through the new
risk profiles and reengage.
In fact, the steps taken so far by the Fed don't really address the actual
credit crunch much at all. It has increased the market marginally for
mortgage-backed securities by making them preferred collateral for its open
market purchases and borrowing from it. Overall, however, its actions have
been designed to increase the availability of short-term capital, when the
supply isn't really the issue.
In its most dramatic move, last Friday the Fed decreased the interest rate
it charges banks to borrow from it, increased the period for repayment, and
encouraged banks to so borrow. Banks, however, have indicated that they
don't really need the money.
Nevertheless, the Fed was seen as doing something, and that appears to have
staunched a broad sell-off of stocks. Given that the Fed's moves made
little sense with respect to what was occurring in the credit markets, and
have had little effect there, it's hard to resist the conclusion that they
were, in reality, actually intended to calm the equity markets.
The stock market, however, can be a tough beast to placate, as Bernanke is
about to learn.
Economic fundamentals are still pretty good. Investment capital is
plentiful, economic output continues to expand, profitability is healthy,
wage growth has improved, consumer spending seems steady.
Inflationary pressures remain slightly worrisome, however. Bernanke seems
to have been maneuvering to give himself room to keep the more important
federal funds rate where it currently is.
Moreover, there is no reason to believe that a rate cut would alleviate the
current credit crunch. Reducing the return on lending is hardly the way to
get lenders to be less reluctant to lend.
Nevertheless, the stock market, which generally prefers easy money, clearly
expects a rate cut, and failure to produce one probably would trigger
another sell off.
That's why the Fed should stick to price stability and let markets sort the
rest of it out for themselves.