Opinion Editorial | |
| Monday, July 13, 1998 | |
Stock Market Rise Doesn't Herald Inflation |
The Federal Reserve recently released the minutes of the May 19 meeting
of its Federal Open Market Committee (FOMC), the organization that formally
determines our nation's monetary policy. Decisions by the FOMC can have
an immediate and dramatic impact on interest rates, especially short-term
interest rates. At its last meeting, the FOMC decided to keep the federal
funds rate, the interest rate on money banks lend to each other, at 5.5
percent. A number of economists believe that the FOMC is keeping the fed funds
rate too high, which in turn causes interest rates paid by businesses and
consumers to be higher than necessary. Economist Brian Wesbury notes that
when adjusted for inflation the fed funds rate is now at its highest level
in over 9 years. He believes that failure of the Federal Reserve to ease
monetary policy and lower the fed funds rate risks a recession. On the other hand, there are also economists who continue to believe
that inflation lies just over the horizon. They believe the Fed should
keep money tight and raise interest rates if necessary to forestall inflation.
"The economy today seems to be nearing the classic stage of overheating
that precedes an acceleration of inflation," writes Rob Norton in Fortune
Magazine. Among the key indicators of concern to the inflation "hawks"
is the continued rise of the stock market. They worry that this may be
the sign of an inflationary bubble that could easily burst with a stock
market crash. They also worry that rising stock wealth may encourage consumers
to buy more than their incomes would ordinarily allow, thus bidding up prices
at the retail level. Federal Reserve Chairman Alan Greenspan clearly has sympathy for the
bubble theorists. A year and a half ago he sent the stock market reeling
by criticizing its "irrational exuberance." More recently, he
testified before Congress that current stock prices can only be sustained
if economic conditions remain "exceptionally favorable." On the
FOMC he is being pressured to tighten money by members such as Jerry Jordan,
president of the Federal Reserve Bank of Cleveland, who sees "too much
cash chasing too few deals." A review of the evidence, however, shows that any relationship between
stock prices and inflation is tenuous at best (see figure).
The reason is because purchases of stock are a form of saving, not consumption.
Since the Consumer Price Index reflects only changes in prices for consumption
goods, rising stock prices cannot be an indicator of inflation. In fact,
many economists believe the main reason why stocks have risen is precisely
because inflation has fallen. Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis,
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