It would seem that the recent--and unexpected--25 percent decline in the stock market would be a sign that it is time to cut interest rates further. After all, if a 1.75 percent nominal short rate was the right thing to do when the Dow was at 10000, it is likely to be higher than optimal when the Dow is below 8000. The argument against cutting rates over the past few months has been the fear it will be counterproductive--that a sign that the Federal Reserve is worried will panic the markets. But, as Paul Krugman has said, now that the markets are thoroughly panicked that argument no longer seems to apply.
Either the Federal Reserve has concluded that the stock market is largely decoupled from aggregate demand, or they must now be thinking how and when to cut interest rates further. The problem is that, with the short safe nominal interest rate already down at 1.75 percent, how low can you go?
Economist: The American Economy: In the Balance
Glenn Hubbard, the chairman of President George Bush’s Council of Economic Advisers, said last week that the drop in American share prices since May might reduce economic growth by 0.4% to 0.7% over the next year. Mr Hubbard was using a rough rule of thumb, no more. Most economists assume that prolonged falls in share prices have a "wealth effect": that is, as people see the value of their shareholdings fall, they feel poorer and curb their spending. But at what point they start to feel poorer, and by how much they cut consumption, has never been easy to measure or predict.
In the balance
From The Economist Global Agenda
With stockmarkets world-wide sunk in gloom, so much now depends on the American economy. Is it doing as well as Alan Greenspan, the head of America’s central bank, has claimed? Or is a continuing slide in share prices about to undermine growth?
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VOLATILE, but going down. Share prices on most of the world’s important stockmarkets have fluctuated wildly in recent weeks, but they have done so around a relentlessly downward trend. America's stockmarkets have led the retreat. On Monday July 22nd, the American markets again began the week sunk in gloom. Both the Dow Jones Industrial Average and the high-tech dominated Nasdaq Composite index fell by nearly 3%. In the two weeks up until last Friday, the Dow Jones index had lost 14.5% of its value, the Standard & Poor's 500 index almost as much and the Nasdaq had lost 8.9%. This had wiped a staggering $1.4 trillion off share values even before Monday's declines, according to one calculation. Recoveries in share prices have been short-lived. This is turning into the longest bear market for many years.
So far, the American economy—perhaps more than ever the locomotive of global growth—has shrugged off the plunge in the equity markets. Last week, Alan Greenspan, chairman of the Federal Reserve (America’s central bank), said the recovery, albeit modest, was still on track. But can it remain immune to a continually sliding stockmarket?
So far most of the data about America’s economy have been encouraging. But the persistently gloomy mood of the markets has prompted some economists to question whether the bear market could derail recovery. This debate ensures that each new set of economic statistics will be scrutinised even more carefully than usual. On Thursday July 25th, durable-goods orders for June will be released, along with figures for existing and new homes sales. On the following day comes the University of Michigan’s widely-respected survey of consumer confidence. All these figures should show whether consumers—until now the mainstay of America’s economy both during last year’s recession and since—are beginning to lose their nerve.
Americans’ addiction to shopping has served their economy well. But it would be hard to find an economist prepared to argue that the share-price slide will have no impact on consumption and thus on the economy. How big that impact will be, though, and when it will be felt, are far more difficult to assess. Glenn Hubbard, the chairman of President George Bush’s Council of Economic Advisers, said last week that the drop in American share prices since May might reduce economic growth by 0.4% to 0.7% over the next year.
Mr Hubbard was using a rough rule of thumb, no more. Most economists assume that prolonged falls in share prices have a “wealth effect”: that is, as people see the value of their shareholdings fall, they feel poorer and curb their spending. But at what point they start to feel poorer, and by how much they cut consumption, has never been easy to measure or predict. It could take quite a long time for people to decide that the paper losses on their investments will not soon be recovered. And although shareholding in America is widespread, most people have relatively small holdings (in 1998, the median household share ownership was less than $20,000). Rich people own most shares, and precisely because they are rich (and already have most of what they want) they have less marginal propensity to consume than those who have less. And whatever the rich do spend represents a much smaller proportion of their overall wealth or income.
So far, the buoyancy of America’s housing market has been far more important to the economy than the fall in share prices. Figures published last week indicated that housing starts dropped in June slightly, and slightly more than expected. And yet, so far, there is little evidence of a significant slowdown in the housing sector. This is one reason why the home-sales figures due on July 25th will be studied so carefully.
With mortgage rates at their lowest in decades, and with house prices rising steadily, many homeowners have been refinancing: switching their loans to take advantage of lower rates and in the process using some of the money raised this way to spend on consumer goods—in effect, spending some of the equity gained on their house because of rising prices. Evidence suggests that rising house prices have a much greater impact on consumption than do rising share prices. This has helped offset plunging share values. But what nobody knows is whether this effect is similarly more pronounced on the way down. The risk, though, is that if house prices were to fall back, or stop rising, Americans will react quickly to the signal, and slash spending.
In such an uncertain climate, policymakers have to strike a delicate balance. Too much gloom can become a self-fulfilling prophecy. Too much sunshine can blind everyone to the risks ahead. A balance was just what Mr Greenspan was seeking to achieve when he gave evidence on Capitol Hill last week. There was useful support for his guarded optimism in the data. Industrial production continued to pick up, and there were further signs of stability in the labour market, with new unemployment claims falling again. Inflation continues to be subdued, as figures released on July 19th showed.
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The Fed chairman also hinted—pretty clearly by his cryptic standards—that interest rates would stay low until he is sure that the recovery is clearly on track. For the time being, low inflation gives him the flexibility he wants. For Mr Greenspan, evidence for sustained recovery will include a pick-up in business investment, which has so far proved elusive. He encouraged firms and investors to look carefully at profit figures, pointing out that, in spite of the recent spate of corporate-accounting scandals, government measures of profits had shown a sharp increase since the third quarter of last year.
As yet, the stockmarkets have not taken much interest in aggregate government figures. They watch the figures that companies themselves report and there has not been much comfort there, at least among large firms. An important test for the American economy will come on July 31st, when the first estimates of GDP growth in the second quarter of the year will be released. Those for the first quarter were unexpectedly good, and were even better by the final revision. Confirmation that the modest expansion is firmly established would come as a relief for everyone. More importantly, it might, just, stop investors from panicking.
Posted by DeLong at July 23, 2002 03:23 PM | Trackback