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The Greenspan Effect

By Daniel Gross
Fellow

The New York Times
December 7, 2000

Since he started boosting interest rates in May 1999, Alan Greenspan, the chairman of the Federal Reserve, has singlehandedly tried to cool off an economy and stock market that he viewed as overheated.

On Tuesday morning, four years to the day after he first warned of "irrational exuberance," Mr. Greenspan proclaimed victory. In a speech, he noted that the stock market, home-building, car sales and demand for consumer durables were all down. Meanwhile, unemployment claims and lending standards were up. With the economy losing momentum, he said, the Fed must "remain alert to the possibility that greater caution and weakening asset values in financial markets could signal or precipitate an excessive softening in household and business spending."

Traders took this convoluted prose as a clear signal: The asset bubble had been pricked. The economy was slowing. And the Fed might start thinking about lowering interest rates as soon as Jan. 30, 2001, when its Open Market Committee meets.

Very quickly, the soundtrack on Wall Street changed from "Stormy Weather" to "We're in the Money." Investors -- stunned into inaction by recent market declines -- emerged from their bunkers and gobbled up stocks. The Nasdaq spiked 10.47 percent, its biggest single-day gain ever. (The Dow Jones industrial average rose a less impressive 3 percent.)

Mr. Greenspan showed once again that he can move markets with a few well-chosen words. But it is also abundantly clear that the markets move Mr. Greenspan. And by the time the Fed meets to consider its stance on interest rates, the environment may have changed; Mr. Greenspan may be worried not about a slowing economy, but about an overheated stock market.

I hate to pour cold water in everybody's eggnog. But the rally on Tuesday wasn't particularly rational. e-Bay soared 17 percent, Cisco rose 13 percent and Network Appliances spiked 38 percent -- all on a day in which Apple Computer announced that its revenues for the next quarter would fall well short of expectations.

The rise in these stocks was not fueled by any improvement in earnings or by a rebound in consumer demand for the goods and services of these companies. It was a result of wishful thinking, prompted by the Greenspan announcement, for a return to the days of cheap, easy money.

That wishful dream could continue, the market declines of yesterday notwithstanding. There is the possibility of a Santa Claus rally: the market gains momentum as holiday cheer builds and the Fed appears to be in a giving mood. Then the January effect could kick in. That's the annual phenomenon whereby billions of dollars in year-end bonuses and profit-sharing checks flow into mutual funds, thus jacking up stock prices further.

January is also likely to bring the inauguration of George W. Bush -- a prospect that contributed to the rally on Tuesday and that could serve to create inflationary pressures. Mr. Bush has pledged to eliminate the estate tax and cut marginal tax rates. The mere expectation of such actions could stimulate excessive demand for everything from stocks to mink stoles. And Mr. Bush has shown little interest in deficit reduction. Add high energy costs and tight labor markets, and you've got a recipe for the Fed to adopt a policy of watchful waiting -- not easing interest rates immediately.

Of course, if Mr. Greenspan indicated that the Fed wouldn't cut interest rates, stocks would fall -- and fast. That would remove the threat of asset inflation -- meaning that the Fed could once again safely consider cutting interest rates.

After Mr. Greenspan's speech on Tuesday, it was tempting to think that "irrational exuberance" had been conquered once and for all. But investors' swift reaction to his low-key victory speech proves that we still have a long way to go.

Copyright: 2000 The New York Times

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