Liberate the Fed From Wall Street’s Clutches

The markets didn’t think Tuesday’s half-point interest rate cut by the Federal Reserve Board was generous enough and responded with a massive sell-off. Though signals coming from the economy remain mixed, indicating that rates might not need to be lower for things to turn around, much of the demand for the rate cut comes from the stock market’s recent abysmal performance.

In light of the $4 trillion in paper losses, with stocks trading at minuscule fractions of their highs, investors wanted an extra large cut to help ease their pain. Now they are hoping that the Fed once more will run to their rescue, cutting rates further even before its next scheduled meeting.

There is a danger, however, that the nation’s attentiveness to the stock market’s every move has fundamentally changed the nature of Federal Reserve Board policies--and not for the better.

Stock market performance cannot be the sole determinant of monetary policy, nor should it be used as the primary indicator of whether the Fed is on the right course. The Fed’s objective is to keep the economy growing while keeping a check on inflation. Period. Generally, a growing stock market--which will always encounter significant bumps along the way--has been considered to be an outcome, not a cause, of a healthy economy.

Looking at the bind we are in today though, one can see how the causality of this relationship has become blurred. With the entrance of more small-scale investors, many of whom have borrowed against their prior paper gains, there is concern that consumers responding to their smaller portfolios will spend less and save more, adversely affecting the economy.

In light of the country’s negative personal savings rates, however, this actually could have long-term positive effects. But shareholders’ predilections for short-term fixes leaves the Fed feeling pressured to cater to market fluctuations, potentially to the detriment of other economic considerations.

For instance, what would have happened if, because of the news of the Organization of Petroleum Exporting Countries’ plans to cut oil production, the Fed had concluded that higher inflation was more of a concern and therefore held off on cutting rates? With expectations as they were, that would have led to a blood bath on Wall Street, far worse than the ugliness we saw. If, on the other hand, a rate cut had not been assumed to be a sure thing, the absence of one would not have been disaster.

It is the Fed’s own past policies that have created the assumption that the Fed will lower rates whenever there is a substantial market decline, pushing share prices back up and capping potential losses for investors. Shortly after entering office, Alan Greenspan dropped rates in response to the October 1987 stock market crash, just as he recently did with his surprise January mid-meeting rate cut after the Nasdaq’s dive. Similar loosening polices were implemented in response to the Asian market meltdown. In each situation, the Fed’s actions may have increased confidence about its commitment to insulating the economy from threats, but at the same time it added to the perception of the Fed as the market’s sugar daddy, always standing by ready to help out.

Market corrections are by no means a sure precursor of an economic downturn. As Greenspan himself recently testified before Congress, “The stock market forecasted five of the last two recessions.” Even now, the Fed is projecting that growth will pick up in the second half of the year.

Often, stock market corrections are in order. This is most likely the case now, when stocks are returning to more normal valuations after what has been a spectacular run. Trying to mitigate the swings of the stock market not only will be unsuccessful over time, but also will be counterproductive. Expectations of a Fed safety net create a moral hazard, encouraging investors to take on more risk than they otherwise should. And propping up markets artificially only sets the stage for a larger fall down the road.

This in not to say that Tuesday’s rate reduction was not appropriate. It may well have been. But the longer there is the perception that the Fed will use its power to bail out the stock market, the more market dependence on the Fed will increase, making it all the harder to undo.

Luckily, beyond his ability to change the cost of money, Greenspan has a second potent tool at his disposal: his words. Merely by peppering his comments with statements that the Fed reserves no special treatment for the stock market, he could slowly shift perceptions. By warning investors that they should expect both ups and downs, he could dissuade mass borrowing against paper gains, which in turn would help protect the economy from normal market corrections.

And as reliance on the Greenspan safety net disappeared, the Fed once again would be free to respond to the signs coming from the broad economy rather than being held hostage to investors clamoring for the impossible promise of a stock market without a downside.