Wall Street and the Fed

April 11, 1994

As the financial markets calm slightly, at least for the moment, the Federal Reserve Board must surely be assessing what went wrong and to what extent it was the culprit. Common wisdom on Wall Street puts the blame for plummeting bond and stock prices on the Fed's decisions of Feb. 4 and March 21 to nudge up short-term rates a quarter of a point at a time to 3.5 percent. But on this matter, subtle distinctions should be made.

Fed chairman Alan Greenspan's theory that a "pre-emptive strike" against inflation required an increase in short-term rates was and is unassailable in the abstract. Inflation is a lagging indicator, meaning its impact must be warded off in advance. To wait is to be too late. It's like throttling down a boat before it reaches the dock.

All the warning signs of inflation -- robust economic growth, soaring sales of both durable and soft goods, a tightening labor market, increasing take-home income -- have become only more visible during the last two weeks of market volatility.

So one criticism of the Fed could be that it waited too long and was too cautious. The central bank had held short-term rates at a low 3 percent rate for a long time, thus encouraging the flow of money to speculative markets. Perhaps it should have acted last October. Perhaps it should have raised rates half a point at a time. There is now a well-founded impression that further increases in short-term rates are unlikely before the Fed's Open Market Committee meets May 17.

The Fed's other miscalculation was to underestimate the influence of highly speculative hedge funds and other exotic Wall Street gimmicks on the markets as a whole. Once the markets got the notion that the Fed was even more fearful of inflation than it was acknowledging, long-term rates took off like a rocket. That was precisely what the Fed and the Clinton administration wanted to avoid, lest it snuff out the recovery.

During the next six weeks, it is a fair guess that Fed experts will be trying to figure out how they can crank this added volatility factor into their economic models. Right now there is a perceived need to reduce uncertainty. This has already been evidenced in the Fed's new practice of announcing short-term rate changes at the end of board meetings, rather than leaving such decisions to Mr. Greenspan personally. Another may materialize in real pre-emptive strikes rather than fine-tuning.

The last fortnight has seen grief come to a number of financial high-rollers, plus a lot more innocents who put their faith in them. But what should be reassuring is that the market drop has been manageable thus far and that the economy is recovering nicely. The International Monetary Fund now projects U.S. growth at a 3.8 percent rate for the year, compared to only 2.6 percent forecast by the fund last October. There could be good times ahead on Main Street, if not Wall Street. What really counts more than the psychology of the markets is the health of the economy.

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