Who's Going Too Fast?

By Daniel Kadlec

Economists ponder the wealth effect the way many of us ponder alien life. They're pretty sure it's out there--but they can't prove it, they don't know how big it is, and they haven't a clue if it's dangerous. All of which is creating a bit of a stir among the dismal-science lot as their famous and thought-to-be-flawless colleague, Alan Greenspan, relentlessly jacks up interest rates to wage an undeclared war on this vague creature.

The wealth effect, simply, is the penchant to spend more as net worth climbs. You probably don't lie awake at night fretting about the problems that increasing your wealth may bring, but it's an issue in Washington because spending is the root of inflation. And inflation is bad. One way to attack it, therefore, is to attack net worth.

These days that means going after the stock market, and there can be little doubt that that's what Chairman Greenspan is up to--even if he won't say so, which he won't. Last week the Fed boss pushed the benchmark federal funds target rate to 6%, the fifth increase in nine months. For emphasis, he raised the symbolic discount rate as well and all but promised more to come. Banks followed by boosting their prime rate to 9%, the highest in five years--meaning higher costs for credit cards and mortgages.

Never mind that the markets shrugged, then rallied. The Dow closed the week up 4.9%; the supercharged NASDAQ rose 3.4%. That may only strengthen Greenspan's resolve. To be sure, the economy has been dangerously robust the past couple of quarters. And the gross domestic product is expected to rise 4.1% this year, well ahead of the Fed's presumed "speed limit" of around 3.5%. The torrid growth rate is what Greenspan cites most often when justifying rate increases.

But GDP expansion is a bit of a paper tiger. The economy grew 4.1% last year and even faster in 1998, yet aside from oil prices there has been no inflation to speak of. Meanwhile, amid all the angst about overheating, there are signs of a slowdown, most noticeably in the crucial housing sector. The dollar is in fine shape. And while rising oil prices have skewed the Consumer Price Index to a three-year high, the core rate is up a very modest 2.1% for the past 12 months.

So, why continue to raise rates? The Fed plainly is paramountly concerned that rising stock prices are creating such a glow around the nation's dinner tables that a family spending barrage is about to render household goods scarce and send consumer prices spiraling through the roof. It's an interesting theory. It's also a leap that could shut down the expansion prematurely and tarnish Greenspan's sterling reputation--potentially derailing Al Gore's presidential train, much as a weak economy did George Bush's in 1992.

Certainly, the bull market has added greatly to Americans' wealth and stimulated extra spending. Greenspan cites long-term studies showing that of every $1 made in the market, 3[cents] to 4[cents] gets spent on restaurants, vacations, curtains and other things in the real economy. Multiplied over trillions of dollars of new market wealth, that translates into billions of dollars in additional consumer spending and a 1%-to-2% boost in the nation's output.

One problem: it's not at all clear that those spending estimates are right. And even if they are, economists say, the wealth effect--presumably present for the past few years--has not generated inflation, and probably won't. Surging productivity gains, stemming from companies' massive investments in technology, enable workers to make enough things fast enough to meet the additional demand that comes with additional wealth--without driving up prices. Consider: when people feel flush, one of the first things they do is buy a new car--and auto sales have in fact been strong. Yet prices for new vehicles have been dropping.

Bruce Steinberg, chief economist at Merrill Lynch, takes issue with Greenspan closer to the root. He says that in recent years only 1[cent] to 2[cents] of every dollar made in the market has been spent on creature comforts. "As the bull market has powered to new heights, people have become more cautious about their gains," he says. "They're less inclined to think of them as a permanent part of their wealth." In other words, they're just as concerned about sky-high tech-stock valuations as the Fed is, so they're spending less freely than if the gains had come in, say, Caterpillar rather than the Munder NetNet Fund.

Moreover, "the bulk of the gains are socked away in inaccessible retirement accounts, not in speculative kitties," says Ed Yardeni, chief economist at Deutsche Banc Alex Brown. He notes that baby boomers, the nation's largest demographic segment, are in their 40s and 50s and deeply concerned about retirement security. They're holding on to, not spending, their market spoils. Indeed, the 401(k) portion of the $11 trillion retirement industry has grown 18% a year since 1990, reports the trade group Investment Company Institute--in near perfect tandem with the stock market.

Another aspect of the wealth effect is worth considering: it's pretty much limited to the wealthy. Only half the population owns stocks. Most who do own relatively little and hold the bulk in a retirement or pension account. They may feel well off, but the only thing they can do about it is spend their paycheck or go into hock. To some extent, that's happening. The consumer-debt burden has never been higher. But the Fed's data show that most market wealth accrues to the rich. On average, households with annual incomes under $25,000 have been seeing their net worth shrink, not rise. And 59% of all households in which the head is not self-employed saw net worth rise less than 1% during the three years ending in 1998.

In putting so much emphasis on a torrid stock market, Greenspan runs the risk that he'll overreact, raising rates so far that he'll cut off the expansion unnecessarily--just as the lower rungs of the economy are starting to benefit. Rate increases take up to a year to be felt throughout the economy. That means that not even Greenspan's first increase last June has fully settled in, and targeting the roaring NASDAQ only raises the stakes that he'll overstep.

"Any hopes the Fed might have had for a significant near-term reversal of the wealth effect evaporated" with last week's stock-market rally, says Ian Shepherdson, chief U.S. economist at High Frequency Economics. He expects increases totaling 0.75 percentage point by fall. Maybe that will finally arrest the dreaded wealth effect. Let's just hope our broad prosperity doesn't get stopped in its tracks as well.

--With reporting by Bernard Baumohl/New York

With reporting by Bernard Baumohl/New York