Last week's announcement that the Federal Reserve was only cutting interest rates by half a percentage point sent the stock market into a tailspin. Investors had convinced themselves that the Fed was likely to cut rates by three-quarters of a percent or perhaps even a full percent. So when they got only half a percent, the bare minimum, there was a massive letdown.
The Fed's response was that it is not targeting the stock market. Its concern is the real economy -- investment, production and jobs. In the long run, the stock market reflects the strength or weakness of the real economy. Therefore, keeping the economy strong and free of inflation is the best thing the Fed can do to help the stock market.
The problem with this argument is that it ignores the rationale that the Fed gave for tightening monetary policy in the first place. In mid-1999, when it first raised interest rates, the Fed said it was concerned about the stock market being too high. Great emphasis was placed on the so-called wealth effect. According to this theory, as individuals' wealth rises, they spend some percentage of the increase on higher consumption. The Fed believed that the huge run-up in the stock market in the previous year or so would thus lead to excessive spending that could put upward pressure on prices and set off a new round of inflation.
In short, as the market increased, the Fed made no secret of the fact that it was indeed targeting the stock market. Its stated objective was to bring the stock market down to a point at which any additional spending attributable to the wealth effect was consistent with higher productivity. Higher spending matched by additional output is not inflationary, while higher spending without additional output is.
As recent Fed data demonstrate, it got its wish. Last year, the total value of corporate equities owned by households fell by $2.5 trillion or 17.6 percent. Of this, the vast bulk -- $2.2 trillion -- was on shares owned directly. The value of these investments fell an astonishing 33 percent. The value of shares owned indirectly, such as through mutual finds or pension funds, by contrast, fell only $300 billion or 6 percent.
Fortunately for households, there was a comfortable increase in the value of their tangible assets, principally homes. These increased by a healthy 10.3 percent in 2000. With household debt rising by just 8.6 percent, the net result was that the net worth of households fell by a modest 2 percent. At the end of last year, net worth hit $41.4 trillion, twice its level just 10 years earlier.
Looking more closely at stocks, it is clear that the vast bulk of the market's rise in 1999, which triggered the Fed's concern, was in the NASDAQ market. This used to be called the over-the-counter market and consists mainly of stocks in smaller companies. The New York Stock Exchange, on the other hand, represents the large "Blue Chip" companies such as those that make up the Dow Jones Industrial Average.
At the end of 1998, the NASDAQ was worth $2.6 trillion, a significant but not extraordinary increase over its $1.8 trillion level a year earlier. But in 1999, the NASDAQ just exploded, doubling to $5.2 billion by the end of the year, with much of the increase coming in December alone. The NYSE was also up for the year, but much more modestly in percentage terms.
What happened is that the NASDAQ became the investment of choice for those looking to cash-in on the huge run-up in technology stocks, most of which are listed on that exchange. The NYSE, on the other hand, was branded as the place for "Old Economy" stocks that had little upward potential in the "New Economy" of the Internet.
All along, there were those warning that the Y2K problem was distorting the NASDAQ. This forced companies to invest large sums in upgrading their computer systems before the year 2000 arrived. Many took the opportunity to throw out their old systems and install entirely new ones. In the long run, this is a good thing that will enhance growth and productivity for years to come. But in the short run, it gave a boost to many computer equipment manufacturers that was bound to fall off once past the Y2K situation.
The Fed apparently interpreted the run-up in the NASDAQ as a continuing phenomenon, when it was really a reaction to a temporary factor. If the Fed had done nothing, there would have been a sharp decline in the NASDAQ over the last year. But it was compounded by higher interest rates that made it more expensive for businesses to borrow for new computer equipment.
Now, having gotten its wish and brought the stock market down to a two-year low, the question is whether the Fed is going to take any action to lift it up again. After all, if the Fed consciously and deliberately brought the market down from a level it considered to be unsustainable, then isn't it morally obligated to lift it up from a seriously undervalued level?
At this point, we are suffering from a negative wealth effect. Just as consumers spend some of any increase in wealth, they scale back consumption when wealth declines. With consumer spending constituting some two-thirds of the economy, it is necessary to get the stock market up again in order to prevent a more severe downturn in the real economy.
As yet, Fed Chairman Alan Greenspan has given no hint that he is even concerned about the stock market meltdown, let alone preparing to take positive action. But at some point, his hand is going to be forced. The nation's capital markets cannot fall as precipitously as they have without impacting the real economy. Not only will consumption slow, but investment will simply dry up. This will ultimately lead to higher unemployment and also reduce productivity growth, which will mean a slower increase in wages.
In my view, the Fed made a mistake in targeting the stock market in the first place. It should have left well enough alone and allowed it to decline on its own, without being pushed by a tight Fed policy. The result has been that good companies as well as bad ones have suffered unnecessarily.
Now the Fed does not want to acknowledge its responsibility and fix the problem it caused by helping the market out of its slump. It fears forever being in a position of having the market dictate Fed policy. If so, it is only because the Fed itself opened the door by deliberately knocking down the stock market in the first place.