The stock market's amazing ability to turn inward and to look only at itself is resurfacing.
To some, the market's persistent weakness has been a harbinger of the economy's pronounced slowing. Today's
gross domestic product
report, showing growth of 2.7% in the third quarter, has added some more grist to the mill. But, through some convoluted logic, people are saying it's time to get bullish, believing the evidence of a slowdown is enough to prompt the
to consider lowering rates in the not-too-distant future, which would help the stock market.
Forget it. The Fed may ease rates in the future -- but not in the near future.
Since June 1999, the Fed has raised the
fed funds rate from 4.75% to 6.50%, and at its most recent meeting
stated that the balance of risks in the economy is still skewed toward higher inflation. While the majority of primary dealers in government securities, when last polled in early October, believe more rate hikes are unlikely, recent inflationary data, continued labor market tightness and consumer spending strength make rate cuts remote.
"I think the Fed sees the economy differently than the Wall Street community does at this point in time, where an excessive amount of pessimism has crept into the economic outlook, driven by a pullback in the
Nasdaq," says Bill Sullivan, money-market economist at
Morgan Stanley Dean Witter
. "We don't see any systemic weakness in the economy that would suggest the Fed's anxieties about inflation and the tight labor market will be allayed."
The unwavering optimism that rate hikes are forthcoming extends to
fed funds futures contract, the best proxy for the market's current view of the Fed. Currently, fed funds futures are fully pricing in a rate cut by March. Anecdotally, 30% of people polled in a recent
column cited potential rate cuts as their reason for being bullish.
But despite the slowed growth in the third quarter, the GDP is still, on a year-over-year basis, growing at a rate of 5.3%. Consumer spending, which accounts for two-thirds of GDP, grew at a rate of 4.5% in the third quarter, in line with expectations, and it has been strong in the early fourth quarter. Still, business investment slowed considerably in the third quarter.
Inflation indicators remain subdued but are no longer as friendly as they've been in the past. The core
Consumer Price Index
, the market's broadest measure of consumer inflation, is rising at a 2.6% rate, compared with 2.0% in September 1999. The unemployment rate is 3.9%, its lowest in 30 years.
"We're in an interesting stage in terms of reacceleration," says Diane Swonk, deputy chief economist at
. "We're still not at what I'd argue is a soft landing yet; the underlying demand is still strong. It doesn't make the Fed feel too easy."
Stocks Won't Cow the Fed
Stock market pessimism certainly isn't enough to move the Fed. Investors have forcefully taken a big chunk out of the valuations of technology shares -- but that's not the Fed's problem. While the Nasdaq Composite is down 35% from its all-time peak, the
Dow Jones Industrial Average is off just 11%, and the
, which Fed officials have cited as the most effective market gauge, is down 15%.
Until a stock market decline results in a significant downturn in both consumer spending and business investment, the Fed isn't going to respond simply to its woes. This is the wealth effect theory -- that substantial rallies or declines in the stock market translate to a similar increase in consumer spending or lack of it. Many economists believe this acts on a lagging basis, and with consumers richer, thanks to the market, than they were a few years ago, the stock market's recent decline hasn't decimated the average balance sheet.
What might change the Fed's mind? How about an earth-shattering crash.
Alan Greenspan & Co. might cut rates to calm the market. Unlike 1998, when the Fed intervened because it judged the health of the entire financial system, and, by extension, the economy to be at risk, a slow steady decline in the stock market isn't going to prompt the Fed to drop interest rates.
"In 1998, there was tremendous leverage in hedge funds, private investors and New York-based financial institutions," says Mickey Levy, chief economist at
Bank of America
. "The Fed was concerned with the whole system. Now, there's much less leverage. When the Fed asks itself the question, 'Is what's going on in the financial markets going to upset the apple cart?' The answer is 'nah.' "
So, while a rate cut, after a few consecutive quarters of softening growth, is possible, for the next few meetings when Fed members debate whether to cut rates, the answer is likely to be "nah."