Wall Street, Main Street, and the Fed

April 20, 1997

Mark Weisbrot
Champaign-Urbana News Gazette, April 20, 1997

One of the fun things about being an economist is that people routinely ask you for advice about the stock market, especially these days when their mutual fund is looking like a sad tomato. I like to make things up using random numbers, like “I’d advise putting about 45% of your portfolio in stocks, 40% in long-term bonds, and the rest in money market funds.” If it is intoned with the proper expression of authority, people seem to take such advice rather seriously.

Of course nobody can predict the stock market, if for no other reason that in the short term at least it is psychologically driven. Which means it will go in whatever direction the major players think it is going. This is one arena where the self-fulfilling prophecy is the norm.But there are a couple of frequently asked questions that have clearer answers. One of these is, “why does the stock market fall when there is good news about the economy– like when economic growth is up, or unemployment drops?”

A good question, and highly relevant to the latest slump. First, the stock market doesn’t always fall in response to good news. In fact, it would seem like it ought to go the other way. The main determinant of stock prices is expected profits, and normally profits rise with a buoyant economy.But there are other factors that enter the picture. First and foremost is the Federal Reserve. The Fed raised short-term interest rates on March 25, whereupon speculation immediately began as to whether they would do it again in May. Since the Fed raises interest rates in order to slow down the economy, any sign of a healthy economy– e.g. lower unemployment, increases in consumer spending– can spur the Fed to hit the brakes again.

When investors are convinced that the Fed will raise interest rates again, a couple of things can happen that would send the stock market down. First, remember that the Fed raises only short-term rates– not the rates on long-term bonds like 30 year Treasury bonds. Since there has to be a spread between long and short-term rates, the Fed’s (anticipated) rate increase can cause long-term rates to rise. With bonds thus paying a higher yield, some investors switch from stocks to bonds. This is especially likely when stocks are valued very high relative to their earnings– as they are right now.Second, the Fed’s (again, anticipated) commitment to slowing down the economy casts a cloud over future corporate earnings. This can cause a sell-off of stocks.

Finally, the direct effect of raising short-term rates is that short-term bonds and money market funds become more attractive, relative to stocks. This also puts downward pressure on the stock market. These relationships are not always explained very clearly in the business press, as can be seen in the reporting on the most recent slump. Investors are described as selling off stocks in response to positive news about the economy because they fear that the economy’s growth will “spur inflation,” or lead to a recession. This is misleading, because it leaves out a crucial link in the chain of causality from good news about the economy to a sinking stock market: the Fed.

It is the Fed that decides– most recently without any visible evidence– that economic growth is risking an increase in the rate of inflation. They then raise interest rates in order to slow the economy down. It is only because of their policy choice that today’s growth threatens to turn into next year’s recession. The Fed’s reasoning, which can be found in Chairman Alan Greenspan’s recent Congressional testimony, is that economic growth and the fall in unemployment over the last few years have given employees too much bargaining power. This bargaining power “threatens” to turn into wage increases, which in Greenspan’s view means rising inflation.

But most businesses have little to fear from a slight increase in the rate of inflation, as the now six-year-old economic recovery continues. They have much more to gain from a growing economy. We do not know how long this economic expansion would continue, or how low unemployment would fall, if the Fed did not intervene by raising interest rates. But it would be nice to have the chance to find out.Of course the worst casualties piled up by our trigger-happy Fed are not in the stock market but in the labor market. Every rate hike means tens of thousands of jobs lost, and this will escalate into the millions if the Fed actually pushes the economy into a recession. If most people were aware of what the Fed was really doing– deliberately throwing people out of work in order to keep wages from rising– workers would be rioting in the streets before the Fed’s next meeting in May.

Maybe some stockholders would join them.

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