TCS Daily


Markets Have Lost Faith In Greenspan

By Kevin Hassett - March 12, 2001 12:00 AM

Our crazy ride through the data continued last week. The market plummeted on Friday in response to whispers of softness from Intel and a surprisingly strong employment report.

What's that you say? A strong employment report harmed the market? Didn't a weak manufacturing report just harm the market as well? Yes, that's right. Let's take a look at why the market has gone down recently when there is good economic news and when there is bad economic news. Federal Reserve Chairman Alan Greenspan will not enjoy the view.

If the data turn very negative, then the economy will clearly have entered a recession. If that occurs, then many high-tech firms with great prospects but little money will go bankrupt. That is NOT exactly a scenario in which you want to be holding the wrong things. Down this possible path, blue-chip firms will suffer earnings hits and these will most likely feed into prices as well. So if we get news that suggests that things are moving south, it makes sense that prices will as well.

If, on the other hand, suppose we get good economic news. Last week, for example, the employment report signaled that the economy was much stronger than expected in the first two months of the year, then we can expect firms to continue to maintain healthy sales. So why didn't we get a big stock market bounce when the employment report hit? The best explanation is that market participants interpreted the news as a sign that the Federal Reserve will be less likely to lower interest rates aggressively in the next few months.

Interest rate policy matters because firms use credit as the basic fuel of business, borrowing money to meet payrolls between big sales months and also to expand capacity. When interest rates are too high, this fuel becomes costly, and those high costs come right out of profits.

The Fed hit the economy with an interest rate shock last year out of a belief that high growth might ignite inflation. In January, it began to ease up on that harsh medicine, but not enough. High interest rates may not have pushed us into recession, but they have almost done so, and may do so yet if they are not adjusted.

That is why good news is so bad for markets right now. The core reason for our economic troubles, at this moment, is the bad policy of last year, a policy that followed from the Fed's apparent reliance on the failed Phillips curve. If we start to grow at a healthier pace, there is no guarantee that the Phillips curvers will not crush us again. Even if they leave rates where they are now, monetary policy will be excessively restrictive.

If we see bad news, we are in trouble because of the weakening economy. If we see good news, we are harmed because the Fed still clings to the Phillips curve.

That is not a pleasant situation, but there is a clear path out. The president is about to appoint several new members of the Board of Governors at the Fed. If he chooses governors who reject the outmoded Phillips curve, we may well find ourselves back in the world where good news is good news.
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