The Fed and Interest Rates

March 15, 2000

For those interested in the movement of interest rates, the meetings of the Federal Open Market Committee are irresistible events. Occurring once every six weeks, these meetings set the course for interest-rate policy. They are usually preceded by considerable hand-wringing among Wall Street pundits who seem to live in constant dread of higher rates. An increase in interest rates, they fear, will bring the bull run in the stock market to a crashing halt.

But in recent months, such apprehension has turned out to be unfounded. Despite four consecutive increases in rates, the stock market, particularly the technology-laden Nasdaq, has moved resolutely higher. Once upon a time, Alan Greenspan, the indomitable Chair of the Fed, had speculated on the possibility of "irrational exuberance" in the stock market -- causing financial markets to plunge precipitously. Investors, with their hearts in their mouths, bleakly surveyed a suddenly grim financial landscape: Had the surging Dow Jones Industrial Average finally met its match?

They didn't have to wait long for the answer. In remarkably short order, the markets turned around and resumed their ascent with renewed vigor. Investors sighed with relief, and continued salting money away in stocks and mutual funds.

Since then, the financial markets have treated Greenspan's occasional admonitions with scant respect. To be sure, a Greenspan testimony to Congress, where he might caution lawmakers about asset-price inflation, might be followed by a pause in the stock market. But the respite would prove to be fleeting as investors, succumbing to the siren call of the dot-coms, would hurry to their E*Trade accounts once again to snap up their favorite Internet stocks.

Greenspan's apparent inability to let the good times roll stems from a concern that sharp increases in household wealth will encourage consumers to spend far too heartily. With unemployment hovering around 4% and the economy operating at capacity, higher consumer spending might lead to an increase in inflation -- the scourge of central bankers everywhere. And so, an inflation-wary Greenspan, risking the ire of millions of investors and homeowners, issues thinly-veiled warnings about the perils of a frothy stock market, and occasionally backs up his words by raising interest rates.

For the time being, however, inflation in the goods market remains quiescent. Strong gains in labor productivity have offset the inflationary consequences of tight labor markets. As long as their employees exhibit rising productivity, firms are willing to pay higher wages without necessarily raising the prices of their products.

Furthermore, till recently, oil remained a steadfast ally of the Fed -- its low price helped keep inflation in check. But now, with OPEC successfully restricting the supply of oil in world markets, the price of this essential commodity has risen sharply. Greenspan, already jittery about wage inflation and uncommonly high stock valuations, must not be pleased. Investors and borrowers, beware: We may not have seen the last of interest-rate hikes.

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