Blame the Fed for the Market's Nosedive

THE WALL STREET JOURNAL October 11, 2000

This week the stock market has tanked, with the Nasdaq average closing yesterday at 3240, below the level it reached after the April crash. Last week the Federal Reserve's Open Markets Committee met and decided to do nothing about interest rates. Is there a connection? You decide.

Since May 1999, when Alan Greenspan first signaled that the Fed was beginning a tightening phase in monetary policy, the Dow Jones Industrial Average has fallen by 5.1%. That's 16 months of a down market in the midst of one of the greatest booms in U.S. history.

The market seemed to find its legs in August when it became clear that the Fed was done tightening, but it has now started to stumble seriously again. The Fed's decision last week to do nothing signals more trouble ahead. In the past, the Fed's most serious mistake was often failing to bring high real interest rates down quickly enough, not pushing them still higher. Soft landings, as in 1985 or 1995, have always involved the Fed reversing itself by bringing rates back down. More often, however, the Fed stopped raising rates only after the economy had already been in recession for several months. Unfortunately, that pattern of doing too little too late has been most predictable at times like this, when world energy prices distorted the measurement of domestic inflation.

The last recession began in July 1990, accompanied by a dramatic surge in oil prices. However, the Fed did not even begin to bring rates down until that November. The central banks of Europe and Japan had also pushed interest rates up, in sync with oil prices, and were also slow to reverse course.

A decade earlier, another U.S. recession began in January 1980. That time, the Fed kept raising rates for three more months after the recession began. The Fed finally noticed the problem, and eased aggressively for a few months in the spring of 1980. But energy prices began rising in the fall, and the Fed responded by pushing rates to levels never seen before, sending the economy into a deep recession. An even earlier recession began in November 1973, and was also accompanied by rising oil prices. Yet the fed funds rate was not reduced for another eight months.

The lesson of 1990, 1980 and 1973 is that it is critically important for central bankers to avoid confusing a surge in world oil prices with a broader pattern of accelerating inflation.

Over the past year, the consumer price index increased by 2.6% if energy is left out, but by 3.3% if energy is included. The producer price index rose by only 1.4% without energy prices, but 3.2% with them. The personal consumption expenditure deflator is up only 1.9% over the year if energy is excluded, but 2.4% otherwise.

In his July 20 testimony to the House Banking committee, Mr. Greenspan worried that "energy prices may pose a challenge to containing inflation." Yet our soaring dollar and low bond yields are consistent with expectations of lower, not higher, inflation. And the weak stock market suggests something other than a soft landing.

If the dollar had been falling, pushing oil prices up faster in dollars than in euros or yen, then higher oil prices might be something the Fed should watch. This time, however, the dollar has been so strong that it worries Europe and Japan, provoking higher interest rates abroad.

Energy aside, U.S. inflation today is no higher than it was in 1998, when the fed funds rate was near 5%. And non-energy inflation is now lower than in 1993, when the funds rate was below 3%. Today's 6.75% funds rate is obviously high in real terms. That was not terribly troublesome while the economy's real growth rate was nearly as high as the Fed's real interest rate. But high real interest rates on cash can quickly become a very big problem when the economy's growth slows, as it almost surely has. To the extent that the Fed's recent decisions to keep rates high were influenced by oil prices, or by such distractions as fine-tuning real growth and stock prices, that is risky business. Fed decisions to do nothing are not necessarily harmless.