NCPA - National Center for Policy Analysis

Tight Monetary Policy Caused Market Fall

April 10, 2000

Few people blamed the Federal Reserve for last week's stock market slide, even though the Fed has said for more than a year that it was raising interest rates to bring down the stock market.

To be sure, the decision finding Microsoft violated antitrust laws probably sparked the steep drop in the NASDAQ. But the Fed has tightened monetary policy to the point where a significant market downturn was inescapable.

A basic problem with monetary policy is that it affects the economy with a lag of about a year. But markets will react sooner, because they are forward looking. Investors buying stock today are not concerned with yesterday's profits or even today's, but tomorrow's.

Furthermore, economic indicators do not move in unison, and even those that normally move together may deviate for a time for special reasons. Lately, the OPEC oil cartel has managed to raise the price of oil. This has clouded the generally deflationary trend of prices resulting from a tight Fed policy.

One indicator with a particularly good track record is the price of gold, which has proven to be an excellent predictor of future price trends. Gold has been especially good at forecasting oil prices. With gold trending down fairly consistently, the current uptick in oil is clearly an aberration. Economist Richard Salsman believes that absent an upturn in gold, oil should eventually fall to $20 per barrel.

Also, economist Jude Wanniski points out that raising interest rates makes it more expensive to raise the capital to drill for oil. Consequently, the number of exploratory oil wells drilled last year was the lowest ever recorded by the Department of Energy. An average of just 151 exploratory wells were in operation, down three-fourths since 1994.

So long as the Fed keeps tightening, investors haven't seen the bottom of the market.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, April 10, 2000.

 

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