Some days it isn’t easy being an economist.
Wednesday morning, when the Dow was down about 270 points, I left my computer screen get a caffeine treat. As I bought an espresso at the local coffee bar, a neighborhood resident whom I barely know nudged my arm and asked, “Do you think the Fed will be able to prop up the market?”
“Probably not,” I replied. She wasn’t happy at my response.
As soon as I got home I clicked the refresh button for Yahoo Finance. “Can the Fed save the Markets?” immediately popped up on a banner. I sighed.
The very fact that a reputable Web site would brandish such a question demonstrates that many of the general public still harbor deep misunderstandings about the capabilities and appropriate role of a central bank.
Can the Fed save the markets? Ask most economists that question and the vast majority will sharply answer, “No.” Many will add: “And it should not even try, either.”
Economists do still argue among themselves about the degree to which a central bank can or should try to manage such aspects of the overall economy as output, prices and unemployment.
Those who follow the thinking of John Maynard Keynes argue that a central bank can use its discretionary control over the money supply, and hence over interest rates, to moderate swings toward high unemployment on one hand or high inflation on the other.
Other economists, who follow the monetarist leanings of Milton Friedman or his intellectual heirs—the Rational Expectationists—argue that central bank attempts to manage economies are usually futile and often harmful. So there’s some division of opinion on whether the Fed should take an active role in managing the U.S. economy.
But on the question of whether a central bank such as the Fed should try to prop up equity markets, or real estate ones for that matter, economists are nearly unanimous: No, no, and no!
The Fed cannot and the Fed should not.
“Wait a minute,” you interrupt angrily, “I’ve got 15 years of 401k contributions riding on this. Don’t give me some Econ 101 lecture about the proper role of central banks. My retirement depends on this. Give me a straight answer, is the Fed likely to do anything next Tuesday to stop this stock price slide that is pushing me back to where I was four years ago?”
Ah, now that’s another question.
While no one on the Federal Open Market Committee believes that it is their job to keep the Dow or Nasdaq above some magic level, many FOMC members may favor some expansion of the money supply that will lower interest rates, improve consumer and investor confidence, lower business borrowing costs and buoy stock prices while it stimulates a slowing economy.
It is a possibility, but don’t bet on it.
The market has been looking for help from the Fed for months now, and successive announcements of monetary easing have given little beyond short-term respite. Market participants fully expect a 25 or 50 basis point cut next week, many hope for 75. These expectations are already fully incorporated into people’s thinking, and that has not kept the Dow from slipping below 10,000.
It is unfortunate that many Americans have attributed so much of our economic success in recent years to the Fed and its chairman, Alan Greenspan.
The media have doted on Greenspan. Bob Woodward’s inanely fawning recent book, Maestro, is a typical example. Greenspan is a good Fed chair. But his power and that of the Fed itself, are vastly overrated. Believing that he has supernatural powers can only lead to bad decisions and disappointment .
So will the FOMC blithely ignore stock prices when it gathers around its polished oval table next Tuesday morning? Probably not.
Its members know that one function of a central bank is to provide some measure of stability when irrational exuberance turns to panic. We will probably get a rate cut of 50 basis points or more.
But the FOMC—and particularly the District Bank Presidents who now make up a majority—does not want to get sucked into a trap of having to support equity markets. A whiff of oxygen, yes, long-term life-support systems, not a chance.
Budding Fed watchers should note that the periodic report on economic conditions released last week showed a slowing economy, but not one in recession. And several district presidents have given speeches or interviews recently in which they stressed the essential health of the underlying economy. There’s no nervousness here.
I sincerely would like to convey more hope to my worried friends. But the idea that some Fed action can effortlessly put the Dow back at 10,700 and the Nasdaq above 2,500 is a forlorn hope.
Old hands have warned for five years that markets were becoming overvalued. For four years, they were scoffed at. Now may be the time to look at the price-to-earning ratios of the stocks in your portfolio and compare them to long-term historical averages.
Hang on or bail out as you see fit. But don’t count on the FOMC to come riding to the rescue.
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.