In suggesting that the stock market was getting overexuberant, Federal Reserve Chairman Alan Greenspan was trying to resolve a dilemma in his job of keeping the U.S. economy on an even keel.
The economy, as reflected in a report Friday showing a rise in the unemployment rate up to the highest level in four months, is slowing. But stock prices continue to rise dramatically, surging since the presidential election a month ago. If stock prices were to continue rising to unprecedented heights, it would limit Greenspan’s ability to adjust interest rates to keep the long economic expansion going.
“The economy right now is where Greenspan wants it, moderate growth, low inflation,” said economist David Jones of the investment comany Aubrey G. Lanston.
“But Greenspan was looking ahead. If the stock market went to 8,000 on the Dow (Jones industrial average) by next spring, he couldn’t raise interest rates without crashing the market,” Jones adds.
And Greenspan is well aware that market crashes disrupt economies. In 1987, after such a crash, the Fed chairman prevented economic disruption by taking emergency measures to expand the supply of money and credit.
It was in seeking to avoid the need for emergency measures in future, that Greenspan Thursday night inserted a few words about “irrational exuberance” in stock prices into an 18-page, dull-as-dishwater speech entitled “The Challenge of Central Banking in a Democratic Society.”
The effect was dramatic. Traders in Asian markets sold stocks immediately and European markets followed when they opened for business. U.S. markets fell sharply at their opening on Friday but recovered later in the day.
If, indeed, he has opened a safety valve and reduced the risk of an overheated market, analysts said, Greenspan once again will have done his job well. Economists said Friday that they are not expecting further disorder in the markets on Monday.
The 70-year old Fed chairman, a New York University-trained economist, does his job in an environment in which his words are studied by financial markets for their implications about interest rates. The Fed determines short-term interest rates and makes policy for banks through the 12 Federal reserve districts.
In Thursday’s speech, he mused about the ambiguity of prices in the present when “the price of a ton of cold rolled steel” is no longer the yardstick of the economy but “the price of a unit of software” is the standard. This led to a discussion of how difficult it is to know “when irrational exuberance has unduly escalated asset values.”
Those words were intended as a signal to economists and leaders of banks and finance houses around the world of the Fed chairman’s disquiet over several forces currently bearing on the U.S. economy.
Among Greenspan’s concerns, economists say, is a fairly sharp rise in hourly wage levels in November’s report. Greenspan is not against workers making more money, but he recognizes that at 5.4 percent unemployment, there are shortages of skilled workers in some industries. And that raises the possibility of wage and price levels accelerating in some of the most technically advanced sectors of the economy.
Another worry is that foreign money is flooding into the United States. Central banks of other countries prefer to hold U.S. Treasury bills and notes rather than gold in their official reserves. This is a vote of confidence in the U.S. economy but it also makes U.S. interest rates even lower than they otherwise would be.
Also, foreign savers and investors are buying U.S. stocks and bonds because their own economies are growing slower than that of the U.S.
All of this concerns Greenspan who is presiding over the sixth year of an economic expansion with inflation under 3 percent a year, a trend he wants to continue. So he signaled his concern.
To be sure, just as Greenspan is not against higher wages, neither is he opposed to high stock prices. Indeed, he would agree with his old colleague Wayne Angell, former Fed governor and now chief economist at Bear Stearns investment company, who picked up on Greenspan’s use of the word “exuberance.”
“There is a lot to be exuberant about,” Angell said Friday in an interview on CNBC. “A world of free economies, the end of communism, low inflation. And most of all, a once-in-a-century change, the coming of the information age.”
That is what has sent the stock market up so rapidly to levels above 6,400 on the Dow Jones Industrial Average. But then Angell cautioned, “You can only count that change once. You cannot say the market should go to 12,000 because of the same information age.”
Greenspan thought, Angell suggested, that the stock market was getting ahead of itself and threatening to unbalance the economy of jobs and industrial output. So he spoke up to reduce the upward pressure.