Markets Should Fear the Fed--but in Moderation

Was it something he said? Of course it was.

The stock market on Tuesday took its biggest tumble in five weeks after Federal Reserve chief Alan Greenspan appeared to dash any hope that the central bank might lower interest rates soon.

At least, that was the best excuse Wall Street could find for the 105.56-point, 1.1% drop in the Dow Jones industrials, and the steeper 1.7% slump in the recently red-hot Nasdaq composite index.

Yet the bond market--which arguably ought to be most concerned about the Fed’s plans--seemed quite pleased with what it heard from Greenspan: Bond yields slid modestly across the board.

Which only goes to show that the beautiful thing about Greenspan’s major speeches on the economy is that “generally there’s a little something for everyone to take away,” noted Rick Schwartz, a bond portfolio manager at New York Life Asset Management.

And how. Greenspan on Tuesday acknowledged that the economy has slowed, weighed down by Asia’s mess (why interest rates are relatively low). But he insisted that growth ultimately may still be too strong, threatening higher inflation (why interest rates may have to rise). On the other hand, the Fed’s own estimates, included in Greenspan’s address, are for a marked decrease in economic growth in 1999 from this year’s pace (why interest rates may not have to rise much).

Confused? That’s part of Greenspan’s job description: Keep everybody guessing, including financial markets.

Over the last nine months, however, the markets have lost much of their traditional wariness of the Fed, a wariness that in eras past has (usually) helped keep stock prices and bond yields from going to extremes.

“Don’t get too nutty,” the Fed has often implied, “or we might get mean”--and tighten credit.

But since last fall, the Fed has been hamstrung. Despite robust domestic growth--and zooming stock prices that have smelled a lot like speculative excess--Greenspan had to leave short-term interest rates alone for fear of making Asia’s economic crisis far worse.

The Fed’s restraint has effectively added more stimulus to an already strong U.S. economy. And with inflation still subdued (thanks in no small part to Asia), stock and bond markets have been in heaven.

In recent weeks, as Asia’s delayed effects and a U.S. business inventory buildup pointed to a definite near-term slowdown, Wall Street has chosen to see good news there as well: Surely the Fed will cut rates soon!

You’ve got it wrong, Greenspan appeared to be signaling on Tuesday. “He didn’t mention cutting rates even once,” said James Annable, chief economist at First Chicago/NBD bank in Chicago.

And so the stock market registered its disappointment.

The bond market may do the same in coming weeks, some analysts say. “My guess,” Annable said, “is the bond market isn’t going to be pleased with this” as it digests the probability that the Fed won’t ease--and considers the strong possibility that Greenspan will in fact tighten credit sometime in the next 12 months.

“The slowdown is temporary, and domestic spending is going to bring us back,” Annable believes.

That’s just one opinion, to be sure. But let’s say Annable is right, and the Fed is going to raise its benchmark short-term rate, now 5.5%, in the not-too-distant future.

Catastrophe for markets?

The stock market typically abhors any rise in interest rates, so some adverse reaction would be virtually certain. The last time the Fed raised rates, in spring of 1997, blue-chip stocks fell about 10%, on average. Many stocks fared worse.

But here’s the key: At 5.5%, that Fed rate probably doesn’t have to rise much for Greenspan to make his point--which is not that he wants to bring on recession, but that he wants the economy to grow at a sustainable rate that won’t put significant upward pressure on inflation. And right now, significant upward pressure on wages and prices is definitely what’s occurring in the all-important services sector of the economy.

Slow that inflation pressure with a quarter-point rate hike or two, and the longer-term outlook for stocks and bonds alike would remain quite bullish--after investors get a much better opportunity to buy than at current prices.

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* CONTRACTION WORRIES: Some analysts detect a shrinking of the economy. A1 . . . Nasdaq rally ends. D4

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The Split Economy

Has the U.S. economy slowed? Yes, in the manufacturing sector, where prices are deflating, not inflating, and wages are rising modestly. But in the far more significant services sector of the economy, wages are surging this year, and annualized price inflation is nearing 3%. Percentage changes for the first half of 1998 at annualized rates:

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Economic sector Average hourly earnings Consumer prices Goods-producing sector +1.8% --0.4% Services sector +4.9 +2.6 Total economy +3.8 +1.4

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Source: BT Alex. Brown