Alan's dilemma

Doug Henwood dhenwood at
Wed Mar 22 21:34:50 PST 2000

Fortune - April 3, 2000

Alan's Little Secret: The Federal Reserve's Hidden Agenda

Anna Bernasek

At any given moment, somebody somewhere isn't going to like Alan Greenspan. That goes with the job. But these days, history's first and only household-name Federal Reserve chairman is generating a lot more criticism than usual. Economists accuse him of making up theories to suit his own purpose, Wall Street is mad that old-economy stocks are suffering at the expense of tech stocks, and there's a general feeling of frustration that the chairman is being far too cryptic. Rest assured, though: Greenspan hasn't suddenly lost his touch. It's all part of a plan.

Remember last summer, when he started raising interest rates? Not wanting to jolt the market, he sent a message that was clear and soothing: Don't panic--slightly higher rates will cool the economy, and then the good times can go on for a lot longer.

It didn't go exactly as Greenspan had planned, however. We were, if anything, too soothed; we skipped the cooling-the-economy part and went straight to the bit about making the plush times last longer. In other words, the market kept going up, consumer confidence shattered records, and we kept spending on everything--bigger houses, cooler cars, the latest laptops and digital cameras, you name it. That was maddening enough for Mr. Chairman. But insiders say what really stunned him was the rapid acceleration in margin debt at the end of last year--not the way investors usually react to rising interest rates. (For more on the borrowing explosion, see "Margin of Doubt," the previous story.) Says David Jones, chief economist at Aubrey G. Lanston, a longtime Fed watcher and author of several books on the subject: "Greenspan became very frustrated after his experience with last year's rate hikes, and he knew something had to change."

Part of Greenspan's problem is that investors don't believe he'll ever let this market fall in a heap. Imagine, for a moment, that you had a magic pill that allowed you to wake up, hangover free, after a long night out on the town. What would you do? In all likelihood, you'd be doing sunrise limbos at the Casbah, wouldn't you? That's how investors are behaving now, believing the market's magic pill is Greenspan. No matter what happens, the thinking goes, Greenspan will make everything turn out just fine. There's no need for any behavior modification on our part. "People are so confident that Greenspan will fine-tune things," says David Hale, chief global economist for Zurich Financial Services in Chicago, "that no one sees a lot of downside risk in the market."

That unshakable faith, flattering though it may be for the Fed chairman, couldn't come at a worse time. Now more than ever he believes the market is driving this economy to excess, and he wants the stock-buying binge to stop--as of yesterday.

So what's a central banker caught in this bind supposed to do? Talk tough, raise interest rates, and use psychology--which is precisely what Greenspan has been doing since February. On one level, he has been uncharacteristically direct, even downright blunt. Rates will rise, he's been warning, until there is hard evidence, thumbprint-on-the-wall evidence, that demand is slowing. That message is now being spread far and wide by Fed presidents and board governors in what appears to be a unified chorus, orchestrated by the Federal Open Market Committee.

On another level, though, Greenspan has become far less straightforward. He doesn't have all the answers, he points out the unknown more than the known, and he has backed away from any explicit comments about stock valuations or how far stocks might have to fall for him to be at ease. What Greenspan's strategy amounts to is this: Reduce the comfort level in the market--throw in some uncertainty, make investors a bit edgy, keep them guessing--and then (cross your central-banking fingers), people will finally stop spending.

Those close to Greenspan say he's looking for any type of market correction he can get. It doesn't have to be big, just something to confirm that the message is sinking in. A sideways movement in stock prices for the next six months would be enough to satisfy him, they believe, while at most he'd like to see a 15% to 20% market drop. Ultimately though, it's not the level of the stock market per se that he's targeting but consumer spending. Indeed, Greenspan might even tolerate a strong stock market if spending on everything else in the economy would just slow down. (Unfortunately, though, that's unlikely to happen, as today the stock market--and particularly the wealth it's created in our 401(k) plans and IRAs--has seeped much more deeply into the nation's psyche than ever in the past).

Part of the market, at least, fainted on cue in response to Greenspan's new message. Within a week of his congressional testimony on Feb. 17, the Dow had fallen 4% and the S&P had slipped 3%. But over the same period the Nasdaq was up 2%. And that's where it has gotten tricky. Will interest rates have to rise further to dampen tech stocks as well? Not necessarily. Greenspan is looking for a correction in the broad stock market, which he tends to track using the Wilshire 5000 index. Just a third of the Wilshire index is made up of tech stocks. That means that new-economy issues could continue to rally, and if the rest of the market falls, the index could conceivably still move sideways and fulfill Greenspan's plan. It's not ideal, but it would work.

What can investors make of all this? First, interest rates are going to rise a lot higher than anyone imagined a month ago. Those close to the Fed believe it could raise its key short-term rate from a current 5.75% to 7% by year-end. Second, be prepared. If there's no immediate slowdown in demand, Greenspan might alter his strategy of incremental rate rises and opt for bigger hikes--a kind of shock therapy. (There are already those on the FOMC, such as Roger Ferguson, vice chairman of the board of governors, wondering publicly whether incremental rate rises will get the job done.) Third, expect the divergence between tech stocks and old-economy stocks to continue for some time.

And finally, don't be surprised by anything Greenspan says or does. He's the master of manipulation, and his goal at this point is to make us all realize there's no such thing as a magic pill. In the spirit of self-interest, it's probably time we paid attention. Otherwise, we might wake up soon with one splitting headache.

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