Will Greenspan Play the Rate-Hike Card?

For a man who normally speaks in riddles and parables, Alan Greenspan last week was amazingly direct.

“Excessive optimism sows the seeds of its own reversal,” the Federal Reserve Board chairman warned on Capitol Hill. He could only have been referring to one thing, of course: the U.S. stock market, which Greenspan has been treating like some kind of mental patient since November.

The continued surge in stocks this year, after Greenspan first hinted on Dec. 5 that prices might be caught up in an “irrational exuberance,” no doubt has irked the central bank chief, who is used to being taken far more seriously.

So last week, Greenspan upped the ante. The Fed, he said, “must remain especially alert to the possible emergence of imbalances in financial and product markets that ultimately could endanger” the otherwise healthy economy.

One possible translation: “I don’t really want to raise interest rates, but I will if that’s what it takes to stop this wackiness in the stock market.”

If you know your Federal Reserve bylaws, however--and there must be at least a half-dozen people who do--you know that regulating stock prices is not one of the duties of the central bank.

The closest the Fed comes to having direct influence on the market is via its control over “margin” requirements, which dictate the amount of stock an investor can buy with borrowed money.

But these days, purchases of stock on margin amount to a relative pittance compared with the volume of dollars being shoveled into stock mutual funds--a record $29.4 billion in January alone.

For Greenspan & Co., the reality is this: The Fed isn’t supposed to raise interest rates just to prick what it thinks might be a stock market bubble. The Fed is supposed to raise interest rates only when it believes the economy is threatened by higher inflation.

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Yet by Greenspan’s own account, inflation remains remarkably subdued. And what better illustration of that than fast-food king McDonald’s Corp.’s plans for dramatic price cuts in its big sandwiches, in a high-risk bid to regain market share.

Isn’t a 55-cent Big Mac good enough evidence that this economy doesn’t need the anti-inflationary medicine of higher credit costs?

Maybe--unless one broadens one’s view of what constitutes inflation trouble.

Thanks to the tremendously productive and cost-conscious U.S. economy, “traditional price inflation is no longer a problem,” says David Lereah, economist at the Mortgage Bankers Assn. in Washington. “But there is another type of inflation in this world: asset price inflation.”

The Fed, Lereah said, conceivably could argue that “they’re in business to keep inflation under control, and asset price inflation is like any other kind of inflation.”

Does asset price inflation--i.e., zooming stock prices--really threaten the economy? History shows that market bubbles can make a mess when they burst. Just think of the Japanese stock and real estate bubbles of the 1980s.

But many analysts contend that Japan was a special case, an entire economy caught up in a cycle of outrageous speculation. The Fed certainly can’t say the same about the U.S. economy today.

Moreover, there is a compelling argument that the stock market’s rise, or fall, isn’t terribly important to the economy either way. As eminent economist John Maynard Keynes once said, “Consumption is a function of income,” not of changes in the value of people’s accumulated assets, says John R. Williams, economist at Bankers Trust Corp. in New York.

Some people may spend more if they feel richer because of their investments--or spend less if their investments drop--but on balance many economists believe the “wealth effect” is muted, especially nowadays, when many investors’ stock assets are locked up in retirement accounts.

Indeed, outside New York City there was little net effect on the U.S. economy in 1988, which boomed despite the horrendous October 1987 stock market crash.

Greenspan surely knows that as well. Even so, his choice of words last week strongly suggested that he is concerned enough about stocks’ current heights to do something about them--like raise the Fed’s benchmark short-term interest rate, now 5.25%, by a quarter or half a percentage point when the board next meets on March 25.

Yet many of Greenspan’s fellow economists believe he is still merely jawboning, trying to focus investors on the risks of overpaying for stocks long before the U.S. situation ever approaches Japan’s of the late ‘80s.

“I think he is just giving some grandfatherly advice to financial markets,” said Williams, who doesn’t see a Fed rate hike soon.

David Munro, economist at High Frequency Economics in New York, thinks Greenspan’s message is simply that “you will have to live with your individual folly” if you pay irrational prices for stocks relative to underlying earnings.

By Friday, with stocks down for three straight days, it seemed as if more investors were paying attention. In Greenspan’s preferred scenario, then, the Dow industrials will soon pull back 10% or so and sit there calmly for a spell--while the economy continues to grow at a moderate, noninflationary pace, wages just edge higher and corporate profits continue to rise.

But what if Greenspan gets all of the above except for lower stock prices? What if, by spring, the Dow is 500 points higher, mocking once more the second-most powerful man in America?

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Former Fed Gov. Wayne Angell, now an economist at Bear, Stearns & Co., thinks Greenspan is in a peculiar situation.

Even if by the Fed’s traditional yardstick of price inflation there is no good reason to raise interest rates, Greenspan has already established that “what we have is a Fed chairman not liking [his own] monetary policy,” or at least not liking one unintended effect of that policy: soaring financial asset values, Angell said.

In fact, Angell thinks Greenspan further “raised the stakes” last week, because he not only took the stock market to task again but also questioned whether bond yields are, in some cases, too low for the true risk of the securities.

“It’s like he says you shouldn’t own equities or bonds” for the time being, Angell said.

In theory, that still leaves plenty of other possibilities for people’s money: real estate, gold, silver, soybeans, etc. But if Greenspan really wants to lure Americans away from stocks and bonds temporarily, probably nothing would work as well or as fast as higher short-term interest rates.

And if that’s what he’s planning, nobody can say he didn’t warn us.

For excerpts from one of the Advanced Stock Selection panels moderated by Tom Petruno at last weekend’s Investment Strategies Conference sponsored by The Times, point your Web browser at https://www.latimes.com/strategies

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Selective Excess

An irrationally exuberant stock market? Well, that certainly depends on what you own. Blue-chip indexes like the Dow industrials and Standard & Poor’s 500 still are up sharply this year, even with the latest selloff. But indexes of smaller stocks, utility issues and technology stocks are suffering. If Fed Chairman Greenspan were watching the Russell 2,000 index of smaller stocks, he might not be trying to talk the market lower.

(Percentage change in price)*--*

Index 1995 1996 1997 S&P; 500 +34.1% +20.3% +6.8% Dow industrials +33.5% +26.0% +6.7% NYSE composite +31.3% +19.1% +5.9% Amex mkt. value +26.4% +6.4% +3.8% S&P; transports +36.8% +12.6% +2.8% S&P; 400 mid-cap +28.6% +17.3% +2.7% Nasdaq composite +39.9% +22.7% +1.4% S&P; 600 small-cap +28.6% +20.0% -0.6% Russell 2,000 +26.2% +14.8% -0.7% S&P; utilities +35.0% -1.9% -1.1% CBOE tech index +53.9% +27.7% -3.2%

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Source: Bloomberg News