In Fed Rate Hikes, Theory, Reality Are Different Animals

So the Federal Reserve Board is going to raise interest rates to brake the economy. On that much everyone (almost) agrees. But what will it mean for the stock market?

From the looks of blue-chip shares, at least, you wouldn’t suppose investors much care. The Dow Jones industrial average has recovered nearly all of its summer “correction” and is within 1% of its record high set in May.

If everybody knows something--that the Fed is going to tighten credit, for instance--then in theory stock prices should already reflect it.

Unfortunately, theory and reality don’t always ride the same bus, especially on Wall Street.

In late 1993, Fed officials were telling anyone who’d listen that they were almost certain to raise short-term interest rates from the 30-year lows that prevailed then. The bullish argument was that stocks could easily handle higher rates because the Fed was just trying to prolong the economy’s expansion by slowing it, not killing it.

Yet when the Fed finally began to tighten credit on Feb. 4, 1994, the Dow plunged 96.24 points to 3,871.42 that day. It was the beginning of a sharp pullback in the market that extended through that spring and shaved nearly 10% from blue-chip indexes, as the Fed continued to raise rates.

As we now know, the Fed was successful at braking the economy with that round of credit-tightening. Inflation stayed subdued, and business activity slowed enough to allow the Fed to begin cutting rates in July 1995. Without a recession to worry about, and with rates falling, the stock market was off to the races again in 1995.

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Historically, however, there is no disputing that the Fed’s decision to raise interest rates has often helped trigger painful stock bear markets. But the relationship isn’t automatic or immediate.

The oft-cited rule is “three steps and a stumble”--meaning that it takes three successive moves by the Fed in raising the cost of money to produce significant stock market pullbacks.

That implies that investors often haven’t reacted badly to the first or second Fed rate hike in a credit-tightening cycle. And in fact, the Fed’s first moves in 1955, 1963 and 1967 didn’t interrupt the bull markets then in progress.

But the reaction was much faster in other credit-tightening cycles: When the Fed began to raise rates in 1953, 1973 and 1987 stocks soon suffered violent downturns.

Of course, there’s often more behind bear markets than just a stingier Fed. In 1973, the Mideast oil crisis and the beginning of the end of the Nixon presidency helped pummel stocks. In 1987, the markets were roiled by a dollar crisis and by the reversal of a wildly speculative period for stocks that most pros knew couldn’t last.

This time, the main argument advanced by stock bulls is that, although the Fed is almost certain to raise its benchmark short-term rates from the current 5%-to-5.25% level to 5.75% to 6% by late this year--with the first increase likely at the board’s Sept. 24 meeting--the central bank doesn’t need to do any more than that to ensure an economic slowdown in 1997.

“No one is going to be upset [by this rate hike],” argues David Jones, economist at Aubrey G. Lanston & Co. in New York. The Fed, he says, is just about to embark on a mid-course correction in policy, not a severe credit-tightening cycle.

What the Fed obviously wants is another economic “soft landing.” That’s what we got in 1995. The Fed also succeeded in keeping the economic expansion of the early 1960s on track with slight credit-tightening moves in 1963 and 1964. And in the mid-1980s, a short period of higher rates in 1984 also arguably extended the 1980s expansion by slowing it.

Even so, when the Fed raised in 1984, stocks went down. The Dow lost 15% of its value, and smaller stocks suffered worse, before the market regained its footing later in the year.

The great risk today is that the Fed doesn’t stop after just two or three small rate hikes. James Bianco, bond analyst at Arbor Trading Group in Barrington, Ill., thinks the central bank will continue tightening as long as the economy appears to have a head of steam, or inflation is rising, or both. It could be a long ordeal, he says.

But if the bulls are right, and the Fed doesn’t have to move rates much, here’s another thought: As in 1957 and 1987, the stock market, with its recent pullback, may already have reacted to a coming rise in rates. Despite a tighter Fed in 1958 and in 1988, stocks rose as the economy grew.

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Stocks and the Fed

The stock market often goes down when the Federal Reserve raises interest rates, but share prices don’t always fall right away, and at times they have ignored the Fed altogether. Here are major Fed credit-tightening cycles, the rise in the Fed’s key lending rate in each cycle, the year the Standard & Poor’s 500-stock index peaked in each cycle, and the percentage decline in the S&P; from each peak. *--*

Tightening Rise in Fed S&P; peak cycle discount rate and decline 1953-54 1.75% to 2.00% 1953,-15% 1955-57 1.50% to 3.50% 1956,-16% 1958-60 1.75% to 4.00% 1957,-20% 1963-67 3.00% to 4.50% 1966,-22% 1967-69 4.00% to 6.00% 1968,-37% 1973-1974 4.50% to 8.00% 1973,-48% 1977-1980* 5.25% to 13.00% 1977,-18% 1978,-17% 1980,-22% 1987-1989 5.50% to 7.00% 1987, -34% 1994-1996 3.00% to 5.25% 1994,-9%

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* stocks gyrated dramatically as rates rose continuously Source: InvesTech; David L. Babson & Co.