August 24, 1999
The Federal Reserve Board votes to raise interest rates by a quarter point. Three experts discuss how the change will play on Wall Street.
PAUL SOLMAN: The economy zooms, the stock market booms, and the Fed raises interest rates for the second time this summer. To help explain it all, we're joined by: Alice Rivlin, who stepped down last month as vice chairman of the Federal Reserve Board to join the Brookings Institution and serve as chairman of the District of Columbia's Financial Oversight Authority; David Levy, director of the forecasting center and vice chairman at the Jerome Levy Economics Institute; and Allen Sinai, chief global economist at Primark, a forecasting and analysis firm.
And welcome to you all. Alice Rivlin, what was the Fed hoping to accomplish today?
|Tapping the economic brakes|
ALICE RIVLIN: I think they were hoping to slow down the economy a little bit, a quarter point doesn't make a lot of difference. But their general perception is the economy is growing at too rapid a rate. It's an unsustainable rate. And it's time to slow it down a little bit.
PAUL SOLMAN: Why raise both the discount and Fed Fund's rate? They don't always do that, right?
ALICE RIVLIN: No, they don't. And the discount rate is not actually very important at the moment, because not many banks are borrowing at that rate. But the effort was not to leave too much of a gap between the Fed Fund's rate and the discount rate.
PAUL SOLMAN: Okay. So the Fed's worried about inflation.
ALICE RIVLIN: It's a little bit worried about inflation.
PAUL SOLMAN: A little bit worried, a quarter percentage point worried.
ALICE RIVLIN: Right.
PAUL SOLMAN: David Levy, is that what you're worried about, inflation?
DAVID LEVY: Well, I'm not worried in the long-term, but I think we are in a position where the unemployment rate has come down enough, and the labor markets have tightened enough so we are getting evidence that pay increases are starting to become larger. And if that could continue, that would become an inflationary pressure that the Fed would have to respond to.
PAUL SOLMAN: Do you worry-- I gather you worry about the stock market, as well, however?
DAVID LEVY: You directing that to me?
PAUL SOLMAN: Yes.
DAVID LEVY: I'm very concerned about the valuations in the stock market, and particularly because we've gotten to the point where it's going to be very difficult to have both rising profits and interest rates that remain flat to keep the stock market from experiencing a decline. And the reason I say that is that if profits continue to rise, employers are going to be hungry to expand and tend to bid up the priorities of labor.
PAUL SOLMAN: Allen Sinai, do you agree with that?
ALLEN SINAI: I think we're going to get a slow down in the rate of growth of profits from cost push factors and because interest rates are a little higher.
PAUL SOLMAN: Cost push, just explain what you mean - we're going to have less corporate profits because...
ALLEN SINAI: What I am seeing is some pipeline inflation in the costs of materials that companies buy that shows up in the Producer Price Index, the lower stages of processing levels, the lower levels of that index. And wage inflation is picking up. Now, that's really a good thing for American workers, but it is a cost to business. So we'll get some eroding away of profits on account of that. And those potentially, if companies can pass those costs on in an active economy with strong demand, potentially could be a source of higher inflation. And I think that's what the Fed was stepping out against. It wants to keep inflation nice and low. Low inflation has been the main source of our great prosperity.
|Is the stock market out of hand?|
PAUL SOLMAN: David Levy, I've read you say that you're worried about the stock market getting out of hand, the Fed not acting strongly enough -- and then a sudden correction, which could have serious effects on the economy.
DAVID LEVY: Well, I would say, the stock market I think has been out of hand for quite a while. We've had a 17-year bull market that's just been unprecedented in American history. And like any major bull market, it's tended to go a little bit on momentum. I'm concerned valuations are already high. And the market is very vulnerable. What makes us particularly concerned is that unlike any other period in American history, the stock market is absolutely dominating the performance of the overall economy -- evidenced most directly through the behavior of consumers who have accelerated their purchases relative to their incomes to an extraordinary extent over the last several years. They now spend more than they receive in income, excluding capital gains.
PAUL SOLMAN: So they're spending because they figure they're rich?
DAVID LEVY: Exactly. And if something should happen to the stock market, and suddenly they don't feel so rich, particularly because a lot of them may have some leverage behind that - those stock market positions, we could see a very sharp pullback in consumer spending, particularly so in this period because so much of what is called - might be called discretionary spending is going on, buying automobiles, buying home furnishings, taking expensive vacations, things that are easy to cut back on if hard times arrive.
PAUL SOLMAN: So they'd stop spending and then that would hurt the economy significantly?
DAVID LEVY: That would be the concern. So I think the Fed is trying to walk a fine line, putting some resistance on the strength of the economy to cool things down, but being very careful not to jolt the stock market and cause a very sharp deflation. I think that's why the Fed bend over backwards in the statement today to emphasize that they felt they had done a lot to fight inflation and to make no-- give no hint they might tighten in the future. Obviously they will continue to watch and take things as they come.
PAUL SOLMAN: Alice Rivlin, that sounds like what the Fed was thinking when it was taking the deliberations it has been taking in the last 24 hours?
ALICE RIVLIN: Well, remember, we've had strong growth in the economy for quite a long time now, and over the last year, the Fed has made three down moves in the interest rates, three quarter points. And now, the economy continues strong. It may weaken, as Allen Sinai suggests, but it hasn't shown any clear signs of doing that yet. And the rest of the world is strengthening. The thing that prompted the down moves of last fall was real concern that the world economy was falling apart and that that could affect the U.S. economy very negatively.
PAUL SOLMAN: And so the U.S. economy had to be kept going for that reason?
ALICE RIVLIN: The Fed responded and may have contributed to the fact that the disaster didn't prove quite as bad as people thought. World economy is reviving; U.S. economy remains strong. And yet interest rates here, short-term interest rates are actually lower than they were a year ago. So the Fed is, I think, doing a partial correction of what might have been an excessive concern with possible weakness in the economy.
PAUL SOLMAN: But you're not... You don't think the Fed is thinking that much about the stock market?
ALICE RIVLIN: Well, the stock market, as David points out, is highly valued at the moment. You have to be very optimistic about the earnings of U.S. companies to think that these values on the average are normal. On the other hand, the Fed can't worry just about the stock market. The stock market is important as it affects the whole economy. And it has to focus on what's happening to the whole economy. Is it growing a little bit too fast? And their move today indicates they think the answer to that is yes. One might have said, well, there isn't all this much inflation, and as Allen said, the economy may slow down. And it would have been arguable to wait a little while. But they decided not to do that -- to take out the insurance against the inflation with another move now.
PAUL SOLMAN: Allen Sinai, I want to get to this connection, because I think a lot of people are interested in the stock markets, since so many of them invest in it. How vulnerable is the economy to a stock market softening, such as you suggested could be possible if the costs were going up for companies and their profits would then go down?
ALLEN SINAI: Well, I think we are more exposed and vulnerable than we have been throughout much of our history. But, relatively speaking, I don't think a good-size correction in the stock market or the stock market itself could really do our economy in. It certainly could dent some categories of consumer spending, but we have to remember that what drives consumer spending more than the stock market is jobs and income. Consumers spend more out of a dollar of income than they spend out of a dollar of extra wealth or net worth that comes from stock market gains. And so long as that's going well, consumers will spend pretty close to trend, which is over 3 percent a year now for the last four years in real terms.
But nevertheless, if we do have a major stock market problem, a big decline, we do have more individuals, more families with more stock holdings as a proportion of assets. We have more pay plans tied to the stock market. We've had a lot of M&A activity which has been motivated because of purchases using inflated stock prices. And executives certainly are remunerated quite well. There is a mantra in the U.S. situation now, which is maximize shareholder value. And all of us are tied more to the stock market than ever before.
And so I think if we had a severe problem in the stock market, it wouldn't happen by itself. I don't really agree with David in terms of valuations. I think in this new world, we are not overly valued. We are well valued. But if we had a major stock market problem, I think we would lose more spending, more jobs, more business activity, more entrepreneurial activity than in the past. But I absolutely do not believe it would be decisive in our business cycle; it would not throw us into a recession or anything near that.
PAUL SOLMAN: So, David Levy, how come the stock market rises as it did dramatically when the Fed raises rates? That is, it's going to tighten the economy. And traditionally you would think that that would be something that would make the stock market go down. And you say it's up at all-time highs anyway.
|Playing the market|
DAVID LEVY: First of all, you know, I think there's the old expression, buy the rumor, sell the news, or sell the rumor, buy the news in this case. And I think what had happened is the stock market got nervous about a series of Fed tightenings and increasingly began to believe there would be fewer tightenings than they had earlier thought. And I think the view is that the Fed has done what it's going to do, and now the stock market will be free to rise without worrying about interest rates. I don't share that view, because I think if earnings are going to continue to perform well, we're going to continue to bid up the price of labor and, you know, you are going to get some interest rate pressures that would upset the market. I also want to disagree with my colleague here.
PAUL SOLMAN: Which colleague?
DAVID LEVY: Dr. Sinai. Allen makes the point that, which is certainly correct, that we spend a lot more out of our wages than salaries, almost all of it, than we do out of our gains in the stock market, which is a tiny fraction. However, keep in mind that the ability of the stock market valuations to change, particularly given how large the market's become at this point, is enormous. We saw a $9 trillion change in the value of the stock market in the past four years. In fact, that's without even dealing with the '99 part of the rally -- from '95 to '98. And you take a way a few trillion, you can get a very sharp decline in consumer spending, enough to wipe out GDP growth in a quarter and trigger a recession.
So I think we have a to be very, very cautious about dismissing that as a risk. And I think, and perhaps the former vice chairman of the Federal Reserve Board, you know, might comment on this, but I think the Federal Reserve has over the years been aware that there is a wealth effect and has certainly been taking that into consideration, even though the Fed very clearly does not want to target the stock market or try to set any limits or deflate bubbles or anything of that sort.
PAUL SOLMAN: The wealth effect being that you spend more if you have more in stocks and you think you're worth more.
DAVID LEVY: If your stock portfolio appreciates, you feel wealthier, you don't feel you need to save, you can go ahead and buy that new car or whatever.
PAUL SOLMAN: All right.
ALICE RIVLIN: There's certainly evidence that that's true, but it can be exaggerated. More people own stock now than used to. On the other hand, not -- the average family doesn't own a lot of stock. They may have some in their pension plan, but they may not be terribly conscious of what's happening to the value of the pension plan such that it would affect their daily spending. So I would rather come out where Allen Sinai does. The reason we've had such... the main reason we've had such strong consumer spending is people have jobs. Their incomes are rising. They feel good about the economy. And they're spending.
PAUL SOLMAN: Okay. Well, let's leave it there. Thank you all very much. Appreciate it.