Thursday, 4 July 2013

Can the Fed Control the Stock Market?

 By Frank Shostak (June 2000)

The recent softening in some economic indicators prompted market players to conclude that the Fed is unlikely to pursue its tighter interest rate stance further. The reason for this view is that slower economic activity will cool off consumer demand and, consequently, the rate of inflation as measured by various price indices will follow suit.

With this model in mind, many market players have concluded that the present stock market has fallen enough and it is a "great buy." For instance after reaching 4696.69 at the end of February the Nasdaq Composite share price index closed at 3400.91 at the end of May, a fall of 27.6%. The Dallas Federal Reserve president further reinforced this view saying that the recent correction in stock prices may help prolong the current economic expansion.

This way of thinking, however, could be wrong. A general rise in prices of goods and services cannot be quickly suppressed by a high interest rate policy. The effects of monetary tightening proceed gradually, while the effects of a previous expansion are not subject to central-bank control.

After falling to a yearly growth of 1.6% in May 1996 the yearly rate of growth in the money base climbed to 15.2% by December last year. Historically, the lag effect from changes in the money base to changes in the consumer price index is about two years. This in turn means that one should expect a further acceleration in the momentum of prices and therefore further tightening by the Fed.

Against this long lag, the effect from a rise in interest rates to real economic activity is much shorter; historically, about one year. This means that there is a growing likelihood that a fall in economic activity will be accompanied by rising price inflation, which is to say there is a risk of inducing stagflation (the combination of inflation plus recession that Keynesians once claimed could not exist). This nasty cocktail could be bad news for financial markets in general and the stock market in particular.

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