Will the Equity Market Wealth Effect
Work in Reverse?

We don't envy Chairman Alan Greenspan and the Fed's Open Market Committee in the coming months. On the one hand, it now seems apparent that inflation is on the rise. Strong underlying demand in an economy where there are few qualified workers left to hire seems to be pushing prices up at last. On the other hand, a significant contributor to the strength in demand is the wealth effect associated with the stunning rise in equity values over the past few years. Mr. Greenspan indicated in a recent Congressional appearance that Fed officials recognize the link between equity markets and increased demand. He noted "the necessary alignment of the growth in aggregate demand with the growth of potential aggregate supply may well depend on restraint of domestic demand, which continues to be buoyed by the lagged effects of increases in stock market valuations. . . the FOMC will have to stay alert for signs that real interest rates have not yet risen enough to bring the growth of demand in line with that of potential supply." This pretty clearly signals a willingness to continue raising interest rates, especially in response to rising equity prices. But, what does the Fed do in response to falling equity prices? Will the April collapse forestall more tightening?

Compounding the Fed's policy dilemma is the widespread impression that the trigger which sparked the sell-off was the unexpectedly high inflation rate reported for March and the fear that such news virtually guarantees the Fed will hike interest rates by at least 50 basis points next month. If the Fed fails to raise rates, the market quite likely will stage a massive rally, and the Fed will be back to dealing with rising inflation and resurgent confidence and aggregate demand.

In commentary written in mid-March (before the April collapse in equity prices) Goldman Sachs economists William Dudley and Ed McKelvey ventured the opinion that the 12% decline in the Dow Jones Industrial Average from the end of December through March 15, 2000 and the 5% decline in the Standard & Poors' 500 were far short of what would be needed to neutralize the impact of earlier stock market strength on U.S. economic growth. They offered three primary reasons:

• The decline was not large enough to significantly harm economic activity. By comparison, during the summer of 1998, both the Dow and the S&P indexes fell 19.3% over a six week period without exerting any noticeable effect on aggregate growth or on consumer or capital spending.
• The recent decline has not lasted long enough. The main reason why the 1998 decline did not dampen growth was that the markets had rebounded by the end of 1998. Goldman Sachs research on the timing of the wealth effect has found that the impact on consumption usually hits its peak more than one year after the impulse on wealth.
• The broadest market indicator had not dropped much as of mid-March. The Wilshire 5000 had fallen only 1.5% during the first 10 weeks of 2000. Since it is the basis on which the Fed staff computes the stock-market component of household wealth, its modest decline seems especially significant for anticipating what Fed officials may be thinking regarding an appropriate interest rate response.

In recent days, we've seen remarkable resilience in stock prices. To be sure, "volatile" continues to be the best descriptor of the equity market environment, but investors for the moment seem to have sidestepped the big correction. However, we've also seen new signs of accelerating inflation, and a consensus is emerging among economists that the Fed will shift to a more aggressive tightening policy at its next Open Market Committee meeting in May. If this has not yet been factored fully into equity values expect some sharp drops over the next two weeks as the market digests the new inflation picture.