A quick quiz as we await the Solomonic judgment of the
Federal Open Market Committee
. Which would you prefer -- to be rich, or to have a lot of money?
This is not a trick question. It turns on the distinction between wealth and income. Yes, the two tend to go together but, like love and marriage, not always perfectly. There must be thousands of farm families in the United States who are land-rich and cash-poor. You can qualify as a millionaire today with a big slug of index funds yet still have only a poverty level of income due to the record low dividend yield on the
owns nearly $100 billion of a stock that pays no dividend; I can't imagine how he makes ends meet. Wealth is wonderful but it's income that cuts it at the butcher shop.
The distinction between wealth and income looms large as the
cogitates on our fate, so it is worthwhile to seek insight into his thinking on the subject of the "wealth effect." Among his remarks to the
Economic Club of New York
on Jan. 13 were these:
We cannot predict with any assurance how long a growing wealth effect -- more formally, a rise in the ratio of household net worth to income -- will persist, nor do we suspect can anyone else. A diminution of the wealth effect, I should add, does not mean that prices of assets cannot keep rising, only that they rise no more than income.
A rise in the ratio of household wealth-to-income is Greenspan's definition of the wealth effect. On that same occasion he reiterated an estimate he'd offered earlier, that the wealth effect has been responsible for about 25% of the inertial U.S. GDP growth rate of 4% over the past three years. Since conventional wisdom now has it that the speed limit for noninflationary growth is most likely somewhere in the range of 2.5% to 3.5%, we can deduce that the wealth effect is the culprit -- or at least one of the usual suspects -- that has generated the inflation risks against which the FOMC is now strategizing about how to defend. By removing the "wealth effect," the Fed, by its own quasi-official estimates, will be able to bring the economy's growth rate back within the speed limit.
One way to look at the ratio of household wealth-to-income is to note that wealth is a direct function of market prices. A round lot of
shares can constitute $9,000 of wealth one day and $10,000 the next. Wealth is determined in asset markets, and markets are said to be forward-looking, i.e. predictive. We can therefore argue that the rapid growth in wealth relative to income in recent years is a prediction that income -- most of which is generated from current production and employment -- will be rising more briskly in the future. That is certainly what buyers of high-multiple stocks believe and hope will happen.
Markets, however, are notoriously fickle -- they may never be wrong, but they can change their minds at a moment's notice -- so it may not be prudent to bank too heavily on this interpretation.
A more straightforward perspective is that wealth and income are related by interest rates. One thousand dollars of wealth invested in bonds will produce income as determined by the coupon yield. A low interest-rate environment will mean a high wealth-to-income ratio.
It follows that Greenspan's concern about the influence of the growing wealth effect is functionally equivalent to a statement that today's interest rates are too low. Indeed, we can pull from his words, without resorting to torture, a confession that they were too low in the late 1990s. Bear down just a bit harder and we can extract an admission that the Fed is now behind the curve.
The FOMC is, right now, struggling with these realities. How can it employ its limited range of tools -- it can exert powerful influence over short-term interest rates but not much over what happens after that -- to put the genie of the wealth effect back in the bottle, without breaking the bottle.
The conventional wisdom has it that a 25-basis-point hike is a sure thing. Perhaps it will be fortified by harsh language that points out that there is more where this one came from. But matching market expectations hardly seems to be the way to get respect, as stocks that meet the Street but miss the whisper number can attest.
A policy pattern that intrigues me as a possible template for the year ahead is the one followed by the Fed -- under the same management -- in 1994. Then it was three 25-basis-point jabs followed by two stiff 50-basis-point hooks, a thunderous 75-basis-point cross and a final 50-basis-points as inflationary momentum slumped to the canvas.
The inflationary momentum that is present today is in the asset markets that have generated a "wealth effect" that has overstimulated U.S. domestic demand. Dip-buyers and momentum players had better be prepared to defend themselves.
Jim Griffin is the chief strategist at Hartford, Conn.-based Aeltus Investment Management, which manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. At the time of publication, Griffin was long Microsoft, although holdings can change at any time. While Griffin cannot provide investment advice or recommendations, he invites you to comment on his column at