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These days, plenty of people would say the Federal Reserve is bent on squeezing the life out of the equity markets. Take Tuesday, May 16. The morning brought news that the April consumer price index (CPI) hadn't budged. A week earlier, the April producer price index (PPI) showed a decline. No apparent signs of inflation there. Yet by the afternoon of the 16th, the Fed raised rates half a percentage point. Never mind that the market knew it was going to happen and had already compensated for it.
It almost felt like persecution. But hold on. Contrary to the recent invectives hurled at Fed Chairman Alan Greenspan, the Fed isn't anti-equities. The central bankers are adhering to their primary focus: inflation control. That means they often have to administer preventive medicine rather than wait until inflation is evident.
Beneath the surface of April's CPI and PPI reports, incipient signs of inflation are lurking. The Fed has to pull them up by the roots. Many observers argue the Fed won't have finished its job until the federal funds rate -- the overnight interest rate the Fed charges banks -- stands at 7.5% (it's now at 6.5% with the latest action) and that it needs to be finished by the end of this year.
SCARY STATS.
If six consecutive rate hikes over the last 10 months, at a time when inflation has hovered around 2%, seems draconian, consider some of the scary statistics out there to back up the Fed's tightening policy. Consumer spending grew at an 8.5% clip the first quarter of this year. Unemployment dropped to 3.9% in April, lowest in more than three decades. And the growth of durable goods manufacturing appears to be slipping because assembly lines are running out of workers to man them. The U.S. economy appears to be bumping up against its limits. Demand for goods could outstrip supply, and that has traditionally been a sure recipe for inflation.
Here's another place to look for the inflation bogeyman. The housing market index of the Mortgage Bankers Assn., which measures builders' expectations of sales and prospective buyer traffic over the next six months, rose 1 point in May, to 63 -- a "strong score," according to the MBA. The data were gathered before a quarter-point hike in average mortgage rates. But the MBA's weekly index showed applications for mortgages to buy new houses in the U.S. rose 13.2% the week ending May 5 from the week before. These indicators imply that people are continuing to spend on housing, despite having to pay higher mortgage rates.
Economists are highly skeptical of the CPI and PPI numbers that came out over the last two weeks. The CPI increased 0.1% in April, vs. a 0.7% increase in March, and the PPI decreased 0.3% in April, vs. a 1% increase in March. They point out that April's moderation in both indexes was mainly due to a drop in oil prices, which have recently come back up. Since many dismissed the rise in these indexes that energy caused the month before, it's only consistent to ignore its impact on the way down as well. "I don't look at the core CPI in a particular month, a quarterly average is a better indicator," says Joel Prakken, chairman of Macroeconomic Advisers, the St. Louis (Mo.) economic consulting firm that was founded by hawkish Fed Governor Laurence Meyer. "It looks like the core CPI will rise 2.75% in the second quarter. That's pretty high."
IMPACT ON WEALTH.
If the Fed looked at only the CPI and the PPI, it would never catch inflation before it arrived in force. That's why it's the Fed's mission to leave no stone unturned in its search for inflation, especially given the current dizzy growth in gross domestic product. "You have to look at the broad indicators of inflation because you may not see it in the CPI and the PPI," says Marci Rossell, a vice-president and chief economist for Oppenheimer Funds. "It can feed over into other areas, and people thought it was feeding over into asset prices."
And here's where the Fed's policy has been interpreted as anti-equity, or even anti-wealth. Greenspan has alluded to the impact that the accumulation of wealth in the stock market and real estate has had on consumer spending, the so-called wealth effect. "The increase in equity prices has fueled demand for bigger cars and houses," says Gary Burtless, economist at the Brookings Institution, a Washington-based think tank. "If the market dropped by 30% and stayed there, it's clear that one of the sources of [consumer] demand would dry up."
Indeed, the Fed's primary target in its maneuvers is consumer spending, and the equities markets are getting caught in the crossfire. But no matter how painful it may be for investors smarting from April's Nasdaq corrections, the Fed needs to brake the economy long enough and hard enough to get consumers to pull back on their spending. If the Fed can't get consumer behavior under control, the U.S. economy runs the risk of getting sucked into an inflationary spiral that nearly always ends in recession.
STUBBORN CONSUMERS.
"Investors have habitually miscalculated [the lack of] consumer sensitivity to Fed maneuvers," says Christine Callies, chief U.S. strategist at Credit Suisse First Boston. "In the tightening cycle that started in 1986-87 and continued into the first quarter of 1989, the fed funds rate had to go up 80% and sit there for two to three years before consumers changed their habits."
Still, some economists continue to argue that technology is having such a dramatic impact on productivity that it will continue to absorb increased consumer demand for goods and services. No one knows for sure if this argument is correct. But one thing the economists do agree on is that government measures of productivity don't accurately reflect how technology is currently capable of stretching the limits of a healthy economy.
For example, the Commerce Dept. has only recently begun to include software production in its measure of economic output even though it has been a vibrant part of the economy for several years. Many corporations have produced their own customized software that has drastically increased the efficiency of making, distributing, and marketing their products.
BORROWED GROWTH. In many ways, "there has been a fundamental change away from the traditional business cycle," says Steven Wieting, U.S. economist at Salomon Smith Barney, referring to the impact of new technologies on productivity. Still, he's quick to point out that economic growth is far too strong to be sustainable regardless of what the accurate productivity numbers are. At the end of the day, "all of this [business-to-consumer] and [business-to-business] activity only accounts for about 1% of total production today, even though we believe it will account for more in the future."
Brookings' Burtless argues that productivity growth isn't strong enough to account for such robust increases in the nation's GDP. The rest, he says, is being borrowed. "Part of the extra demand is being satisfied by imports and causing the trade balance of the U.S. to deteriorate," he says. As overseas economies recover, they also create a demand for U.S. goods and services, tightening the labor market one more notch. Once again, we end up with the potential for inflation staring us in the face. The Fed is just doing what it can to control it.
The Fed's statement after its Open Market Committee meeting on May 16 suggested that more hikes are likely later this year. And after all the moaning of investors who don't like getting pinched by rate hikes in the short term, the fact is that equity markets benefit from low-inflation periods in the long run. "It has been 20 years in the making, but the Fed has succeeded in undoing the inflationary cycle of the '60s and '70s," says Salomon's Wieting. "There's no way we could have had the fabulous equity markets of 1995 to 1999 with inflation. Preemptive policy is what the market needs now." So hat's off to Greenspan & Co. They're doing the right thing.
Popper covers the markets for Business Week Online EDITED BY BETH BELTON
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