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http://www.businessweek.com/bwdaily/dnflash/mar2000/nf00331a
.htm
SOUND MONEY
BY CHRISTOPHER FARRELL MARCH 31, 2000
Blame the Exuberance on the Fed
Investors are just acting rationally on what the Fed has
preached for years -- the economic benefits of stable prices
Once again, the phrase "irrational exuberance" is haunting
Alan Greenspan and the money mandarins at the Federal
Reserve Board. How else to explain why investors seem to be
paying little heed to the rate hikes engineered by the
central bank? The stock market is unusually volatile yet
remains remarkably strong. Long-term bond yields are down
sharply, too. For instance, 30-year Treasury bonds, at
5.93%, yield less than six-month Treasury bills, at 6.13%.
I have a different take. I'd argue that investors are
behaving quite rationally. They've simply absorbed the
lessons the Federal Reserve Board has taught them over the
past two decades.
Under the leadership of Paul Volcker and more recently
Greenspan, the Fed has lectured the nation for almost two
decades now on the economic benefits of low inflation. Yes,
the struggle to bring inflation down is painful, the Fed
governors said, but the reward is strong growth and low
unemployment. When prices are stable, relative price
fluctuations more accurately signal changes in supply and
demand. That results in better allocation of resources
toward the growth sectors of the economy and away from
stagnant activities. In contrast, inflation muddies the
price signals and sends out a lot of misinformation about
what consumers and businesses do or don't value.
GROWTH MANTRA. The Fed has also let it be known that the
nation's central bank occasionally may make a preemptive
strike against incipient price pressures. Not because the
Fed is anti-growth or mean-spirited, but to maintain the
price stability that allows growth to flourish, the argument
goes. "For the Federal Reserve and monetary policy, this
prescription implies a policy designed to achieve and
maintain low inflation, not because low inflation is an
important stand-alone goal, but because it is the most
significant contribution monetary policy can make to
sustained growth and prosperity," said Gary Stern, president
of the Federal Reserve Bank of Minneapolis, in 1998.
What's more, in congressional testimony and in speeches
given around the country in recent years, the Fed's mantra
has been that economic growth does not cause inflation.
Here's what Thomas Meltzer said in a talk he gave in 1997,
as the then-head of the Federal Reserve Bank of St. Louis:
"In fact, the idea that growth does not cause inflation has
been widely recognized in economics since the 18th century
economist and philosopher David Hume wrote his famous tract,
Of Money, more than 200 years ago."
Now take this Fed-constructed intellectual edifice and apply
it to today's market. Long-term interest rates are coming
down because investors rationally expect inflation will stay
low. Yes, the economy is growing at a rapid rate, and
unemployment is at a three-decade low. But rapid economic
growth won't send the general price level spiraling higher
so long as the monetary authorities are vigilant. And lower
interest rates offer critical support to high stock market
valuations. For example, assuming a 5% profit growth over
the coming 12 months and a 6% yield on the 10-year Treasury
bond, the stock market is overvalued by almost 40%. But the
overvaluation figure is cut in half if the long bond
averages a 5% yield. What's more, in a stable price
environment, stock prices should sport higher price-earnings
ratios than in the 1970s and 1980s.
HOARY SIGNAL. A hard look at the economics suggests that
investor expectations are modest. Historically, the best
predictor of the swings in the business cycle has been yield
curve. Specifically, the yield difference between
three-month Treasury bills and 10-year Treasury bonds
carries a lot of information about the economy's outlook. A
hoary recession signal is an inverted yield curve, when
short-term rates are above long-term rates, because it
reflects an extreme Fed tightening. Conversely, the steeper
the yield curve the better the economy's prospects. Right
now, the Treasury yield curve is inverted, but the pattern
is suspicious with the huge paydown of public debt currently
under way.
Instead, Bruce Steinberg, chief economist at Merrill Lynch,
compares three-month commercial paper yields with high-grade
corporate bonds. Based on historic relationships, the spread
of 150 basis points (one basis point is one-hundredth of a
percent) tells him the market is anticipating that economic
growth will moderate from its current pace of 6% or so to a
3.25% rate during the next year. At the same time, he adds,
the market puts the probability of a recession at a mere
10%.
I'd argue that it's time to put the memorable phrase,
irrational exuberance, to rest. When he made his famous
remarks in December, 1996, Greenspan was raising the point
that maybe investors were risking too much in the stock
market. But investors were -- and still are -- acting
rationally by anticipating that the good times will
continue. Indeed, it's hard for me not to believe that it's
the Fed that's behaving somewhat erratically, not the
markets. The economic story the nation's central bank put
forward over the past two decades is built on careful
research. There's no good reason to abandon that worldview
now.
Farrell is contributing economics editor for Business Week.
His Sound Money radio commentaries are broadcast on
Saturdays in 170 markets nationwide
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