Opening Statement by
Monetary Policy Subcommittee
Committee on Banking and Financial Services
Last month Federal Reserve Chairman Alan Greenspan testified before this committee to give his view of the current state the economy and monetary policy. At that hearing Chairman Greenspan stated: "how the current wealth effect is finally contained will determine whether the extraordinary expansion that it has helped foster can slow to a sustainable pace, without destabilizing the economy in the process."
While the Federal Reserve does not normally concern itself with the price levels of the various indexes in the stock market, some economists argue that the Feds recent focus on the wealth effect has led it to focus on equity price levels to a greater extent than ever before. Alan Greenspans latest testimony explains why stock market levels may have become one of the key factors in determining monetary policy. In his February 17 testimony, Fed Chairman Greenspan observed that:
Historical evidence suggests that perhaps three to four cents out of every additional dollar of stock market wealth eventually is reflected in increased consumer purchases. The sharp rise in the amount of consumer outlays relative to disposable incomes in recent years, and the corresponding fall in the saving rate, has been consistent with this so-called wealth effect on household purchases.
If you take the increase in market value of all US stocks in 1999 ($ 2.76 trillion) and multiply it by 3.5 percent, you can determine that the rise in stock wealth in 1999 increased annual consumption by roughly $96 billion. This accounts for about 30% of the growth in consumer spending. And because consumer spending accounts for two-thirds of overall U.S. economic growth, the Fed fears that continued acceleration in consumer spending will cause the economy to overheat.
After Greenspans Humphrey-Hawkins testimony, finding a method to contain the wealth effect has become a hot topic of debate for economists and market analysts. Many economists, including those at Morgan Stanley and Deutsche Bank, argue that raising margin lending requirements may be a better approach than raising general interest rates.
Our hearing will focus on whether Federal Reserve interest rate decisions should be influenced by market valuation and speculation, and if so, the appropriateness of responding to the financial markets with general rate increases as opposed to margin lending requirements.
Raising short-term interest rates is the normal method used by the Federal Reserve to influence the direction of the economy. The leading firms on Wall Street unanimously expect the Federal Open Market Committee (FOMC) to raise the key 5.75 percent federal funds rate on overnight lending between banks to 6.0 percent at the March 21 meeting. This would be the second rate hike this year after a similar move at the Feb. 1-2 FOMC meeting and three others in 1999.
What is the cause for all of these gradual interest rate increases?
Normally, the Federal Reserve would look for signs of inflation in the labor markets, various commodity price indexes, and other leading indicators of inflation. Despite phenomenal growth in the economy and record levels of employment, these traditional inflation indicators show little signs of inflation (excluding the sharp rises in oil and related industries).
In searching for the rationale behind the recent increases by the Fed, many economists have focused on the wealth effect and its relationship to stock prices. The wealth effect can be described as increased spending by consumers due to an increase in capital gains. The last few years have seen meteoric rises in stock wealth and property values, and these factors have contributed to increased spending. Alan Greenspan has often cited his concern that this additional spending may create greater demand than potential supply, which would result in inflation.
The Fed's quarterly "flow of funds" report found that Americans held $13.33 trillion in stock -- including individual investment accounts, mutual funds and shares in employee-controlled retirement accounts --at the end of 1999, up from $10.57 trillion in 1998. Stockholdings, meanwhile, made up an ever-larger share of overall household wealth, accounting for 31.7% of net worth in 1999, up from 28.34% in 1998. This additional stock wealth may partly account for the increasing role of stock wealth as a factor in the wealth effect.
In his effort to contain the wealth effect, Chairman Greenspan has set a goal of limiting the increase in stock prices to match the growth in personal income, which has averaged about 6 percent in recent years. By setting a target for the growth of the stock market, Chairman Greenspan appears to have set on a course of increasing general interest rates until stock prices fall into line with the more moderate growth in personal income.
Normally, when the Fed increases short-term rates, the dollar strengthens, bond rates rise and stock prices fall. But the Feds recent spate of interest rate hikes has not been successful in lowering certain segments of the stock market, and particularly not the so-called "new economy" stocks of biotech, internet, and telecom companies.
Recently, the values of the "new economy" stocks listed on Nasdaq have greatly increased in relation to the value of "old economy" stocks. For instance, the Wilshire 5000 index has increased by nearly 23 percent for five years running, but it has risen very little this year. The same is true for the Dow Jones and S&P 500: after years of marked increases, they have fallen relatively flat since January 2000. On the other hand, the Nasdaq composite index, heavy on "new economy" high-tech stocks, is up around 40 percent in the last three months, despite some recent losses.
This leads to the question of whether Greenspans strategy is working for the stock market in general, but not for the hyper-active Nasdaq index. The new economy stocks are much less susceptible to increases in short term interest rates since the high-tech companies can raise money through stock sales and therefore rely less on interest sensitive bank loans.
How to tame these high-flying stocks becomes even more critical as it appears that the Fed is resolved to lower the growth in stock prices with general interest rate increases, which have negative secondary effects on average Americans who want to purchase homes, cars, or finance their childrens education. Unless some way is found to restore the rise in stock values to Greenspans 6% target, then interest rate increases will continue to rise and the cost of loans will increase, GDP growth will decrease, and an economic downturn could be the ultimate result.
Some economists have pointed to the role of margin lending in building up the value of the new economy stocks. In the last year, there has been a substantial increase in margin lending, with margin debt levels surpassing $265 billion in February 2000. Margin lending occurs when shareholders borrow money from banks or brokers to purchase stock. The Federal Reserve sets minimum standards for buying securities on margin, although individual exchanges and firms can establish more stringent limits. Under the Fed's rules, investors who want to buy on margin can use debt to finance only up to 50% of a stock purchase. After the stock is bought, maintenance margins set by the exchanges require that debt can climb to no more than 75% of the value of the stocks in the account.
While the increase in margin debt by itself may not be alarming, what causes more concern is that it appears that most of the increases in margin lending have been focused in the new economy stocks. (This information was provided by the Securities Industries Association, which can not reveal exactly which specific stocks are involved. They were able to say that most of the increases in margin lending is in the "new economy" stocks.)
One approach to lowering the rate of increase of flying Nasdaq stock prices is to decrease some of the demand for them. Since it appears that margin lending is focused on these stocks, decreasing the availability of margin financing would lower the demand for these stocks. Today we will hear from Paul McCulley, of Pacific Investment Management Co., who contends that the Fed ought to raise margin requirements rather than interest rates to cool the stock market. McCulley believes the Fed, by raising rates, "has been trying to get the attention of the gluttons in the market by starving the anorexics." Mr. McCulley argues that margin requirements, "are a tax on speculation, and economic theory tells you that if you have a tax on something you will get less of it." Raising the limits on margin lending will inevitably weaken demand and therefore should decrease the price of these new economy stocks.