Duke of Moral Hazards? Fed Cuts Could Send the Wrong Message

SAN FRANCISCO -- Consumer confidence, it seems, has become the Holy Grail of monetary policy. News today that the Conference Board's Consumer Confidence Index slid to 114.4 in January, its lowest level since December 1996, has many on Wall Street believing there's going to be additional salvation coming soon from the Federal Reserve.

The report -- the expectations index fell to 77 from 96.9 in December -- pretty much confirmed expectations the Fed will lower rates by 50 basis points tomorrow. Some observers even seriously discussed whether the Fed might ease by 75 basis points, or perhaps by 50 tomorrow and then cut again prior to its next scheduled gathering on March 20.

Buoyed by such scuttlebutt, the Dow Jones Industrial Average rose 1.7% behind notable strength in economically sensitive components Procter & Gamble (PG), 3M (MMM) and DuPont (DD). Broader market averages struggled to match the Dow's pace, however; the S&P 500 rose 0.7% and the Nasdaq Composite finished almost imperceptibly higher.

Consumer confidence being the key comes from no less authority than Fed Chairman Alan Greenspan.

"The critical issue we need to address is whether that degree of [economic] contraction is enough to breach the fabric of consumer confidence," Greenspan said in the Q&A following his testimony last Thursday.

As we'll see in a moment, the importance of consumer confidence to Fed policy is becoming controversial, because of confidence's increasingly direct connection to the stock market.

The focus on consumer spending is obvious, given that it still accounts for about two-thirds of Gross Domestic Product; "personal expenditures" were $6.8 trillion out of a total $10 trillion GDP in the third quarter of 2000, according to the Bureau of Economic Analysis. (Fourth-quarter figures are due tomorrow.)

Continued strength in the employment sector is the first thing skeptics of the slowdown/recession scenario note. But unemployment is a lagging indicator, and myriad recent layoff announcements -- the latest coming from Amazon.com (AMZN) after the close -- may or may not heavily influence the January figures, due on Friday. But consumers see the headlines, hear Vice President Cheney reiterate his recession call on Meet the Press and other pundits make similar pronouncements, and start to worry about their own jobs and thus, spending habits; hence the heightened importance of confidence indicators.

Something Old, Something New

A relatively new twist in the time-honored relationship of job security and consumer confidence is the stock market. As the portion of U.S. households owning stocks has increased, so, too, has the link between consumer confidence and the stock market, particularly the Nasdaq. The apparent disconnect between the January confidence figures and the Nasdaq's rally can be attributed to the fact the Conference Board conducts its survey in the first half of the month, according to James Bianco, president of Bianco Research in Barrington Ill., who predicts a rebound in confidence in February's report. (Note: The confidence figures in the chart below are from the University of Michigan's survey, whose next report is due on Friday.)

Running Together Consumer confidence and the Nasdaq becoming intertwined

Source: Bianco Research

If Fed policy is directly linked to consumer confidence and consumer confidence is directly linked to stocks, then Fed policy is directly linked to stocks, according to the unofficial economic version of the law of transitive property of equality, wherein if a=b and b=c, then a=c.

In a recent interview here, Ned Riley, chief investment strategist at State Street Global Advisors in Boston, called the Nasdaq "the most important economic indicator" because of its impact on consumer confidence and, therefore, monetary policy.

The possible linkage, or at least the perception thereof, is of paramount concern to Fed critics (myself included) because it can create a moral hazard.

While some theorize that it was dismal National Association of Purchasing Management data, or the California utility crisis, which spurred Greenspan to act, "I'm a big proponent [of the notion] the Fed's move on Jan. 3 was primarily Nasdaq-inspired," Bianco added, recalling that Jan. 2 -- when the Comp fell 7% -- was the biggest single day of outflows ever from equity mutual funds. "The argument is the Fed knew this and said 'Let's pull the trigger now just in case' " another $13.1 billion is going to come out of the market.

Bianco has been critical of the Fed's policymaking and said in an email exchange today that "moral hazard is an extension of that criticism. ... I wish the government would get out of the bailout business. It encourages reckless speculation."

The Fed's public affairs office did not return calls seeking comment, but Greenspan is "concerned he's being interpreted" as focusing on stocks and creating a moral hazard, according to Michael Lewis, founder of Free Markets Inc., a Chicago-based economics consulting firm.

Lewis, whose firm serves mainly institutional money managers and corporate planners, claims to have a colleague who regularly speaks to the Fed chairman (the economists' version of a sports fan claiming to have a friend who plays hoops with Michael Jordan). Lewis does not believe the Fed's intent is to be viewed as the market's savior, noting the reality of last year's action in the Comp suggests it isn't.

But if Greenspan is truly concerned about the perception, he didn't make it evident last week. Speaking about the fallout from productivity gains, he made one of his most overt acknowledgments, to date, on the influence of stocks on the economy:

The sharp increase in prospective long-term rates of return on high-tech investments would not have emerged as it did in the early 1990s, and the associated surge in stock prices surely would have been largely absent. The accompanying wealth effect, so evidently critical to the growth of economic activity since the mid-1990s, would never have materialized.

There's nothing "wrong" with the Fed acknowledging the rising influence of stocks on the "real economy," and history says you have to give the Fed the benefit of the doubt when it comes to its ability to positively affect stocks through easing. The problem is if investors believe the Fed will rescue them if things get really dicey, they may take undue risks.

Furthermore, some believe the central bank is now compelled to ease if (if!) major averages, notably the Comp, revisit their Jan. 2 lows anytime soon. That can become a vicious cycle, for should Fed future easing fail to sustain stocks and/or consumer confidence, the bank's power to do so may wane just a little bit. That's significant, because perception is a powerful thing.

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