1) Does strong economic growth increase inflation?
2) Does slow growth reduce inflationary pressures?
3) Does tight money slow the economy?
4) Does a tough monetary policy raise interest rates?
The answer is yes to all four questions for most market participants -- but not necessarily for everyone else. Think about the stories you've read and heard lately about a looming market correction. A typical narrative runs along these lines: Investors have driven the market to unsustainable heights, perhaps so much so that another bubble may be in the making. The Federal Reserve will hike interest rates when it becomes convinced the economy is strong enough to generate healthy job growth. Rapid job creation and a falling unemployment rate will renew inflation pressures. A Fed-engineered rise in rates translates into lower corporate earnings. The stock market will fall.
Well, if you're a Wall Street trader buying and selling securities by the minute, hour, and day, this likely scenario is nerve-racking and perhaps feels imminent. What's more, the notion that any market reaction will be muted because Wall Street will price a Fed tightening into the market is probably wrong. The futures market is predicting the first tightening move may happen at the August meeting of the Federal Open Market Committee. Yet the Fed could raise rates several times, and the uncertainty over just how many shifts in monetary policy are in the offing would unsettle investors.
STAYING PUT. The increase in market rates could be greater than expected if corporate and government credit demands are voracious at the same time. Households, corporations, and the government are highly leveraged. The concern is growing about a debt implosion when rates move higher. Investors may react more negatively than past business-cycle experience suggests, considering today's record repayment and debt obligations. "For this last reason alone, we shouldn't be complacent about a 'mere' [half percentage point rise in] the short rate," says David Rosenberg, chief economist at Merrill Lynch & Co.
Still, everyone other than Wall Street traders should cheer a Fed rate hike -- and not change their portfolios. When it comes to all the Street advice on reacting to a market correction driven by a Fed tightening, the right response is to repeat that famous Brooklyn mantra: Fuggedaboudit.
That's the bottom line of an important essay penned several years ago by Laurence Siegel, director of policy research in the investment division of the Ford Foundation, and Paul Kaplan, chief economist at Ibbotson Associates ("Good and Bad Monetary Economics, and Why Investors Need to Know the Difference" originally appeared in Investment Policy Magazine and can be found on the outfit's Web site by scrolling down to the Monetary Economics section).
STABLE COMMITMENT. Investors with a time horizon longer than several months should realize that strong economic growth and a low unemployment rate are good news for the economy and corporate profits, and say nothing about inflation prospects. Rapid economic growth doesn't cause inflation. A low unemployment rate doesn't cause inflation either.
Put it this way: How can more people working and earning a paycheck devalue the currency? They can't. No, what would cause inflation is if the Federal Reserve kept monetary policy loose -- say, to help get George Bush reelected -- or tried to keep interest rates artificially low in an effort to stave off the day of reckoning among highly leveraged borrowers.
Fact is, a hike in the Fed's benchmark interest rate simply tells the market that the central bank remains committed to price stability. Indeed, the signal may be more psychological than real. Greenspan's favorite inflation indicator -- the core-consumption deflator -- is up a mere 0.7% year-over-year. Yet investors may want some credible reassurance that the Fed is vigilant against inflation.
MOOD SWINGS. If all this doesn't convince you, consider what Warren Buffett, the greatest investor of the last half-century, would say about the possibility of a market correction. Two words: Ignore it. Don't let "Mr. Market" tell you what to do with your money, Buffett has repeatedly warned. Mr. Market is neurotic. He suffers from dramatic mood swings. One day, he's depressed. The next day, he's euphoric. It's too easy to lose money trying to keep up with Mr. Market. The only people who make money from your trades work on Wall Street.
This counsel can be forgotten amid all the anxiety-inducing headlines raising the specter of falling stocks. But investors should just focus on deciding how much of their portfolios should be in stocks, bonds, cash, and other assets. Then, adjust the portfolio when needs or wants change. Does retirement loom? Did you lose your job? Get an inheritance? Maybe you have the opportunity to take a once-in-a-lifetime trip? These are the sorts of events that can dictate a change in strategy, not anticipation of a market correction or a Fed rate hike. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online