NCPA - National Center for Policy Analysis

Interest Rates And Stock Prices

February 28, 2000

Last week, Federal Reserve Board Chairman Alan Greenspan once again threw financial markets into turmoil by raising anew the prospect of higher interest rates. He blamed the stock market, which he views as fueling excessive consumption. Unless consumption growth slows, he said, it will eventually lead to inflation.

Once again, the main culprit Greenspan fingered is the so-called wealth effect -- the theory that when stock prices rise people feel richer, leading them to cut back saving and increase spending. Greenspan attributes the decline in personal saving from 8.7 percent of disposable personal income in 1992 to just 2.4 percent last year on rising stocks.

Amazingly, Greenspan also blamed rising productivity for creating economic imbalances. Higher productivity, he says, becomes capitalized so quickly into stock prices that wealth -- and hence spending -- rises faster than output.

Greenspan appears to be saying that higher productivity is not altogether a good thing. Yet all economists know that productivity is the key to higher growth and living standards.

Another problem is the potential for moral hazard -- which is when policies unwittingly create the problems they are designed to cure. Using Fed policy to bring down an "exuberant" stock market implies Fed policy would be used to prop-up the stock market on the downside.

However, the stock market often rises and falls for reasons unrelated to monetary policy, and using interest rates to offset those factors can easily make matters worse. For example, the stock market was weak in the 1970s because of inflation. Easing monetary policy in order to raise stock prices would only have exacerbated the problem.

Saving is falling less due to the wealth effect than because of budget surpluses. Consumers view surpluses as equivalent to tax cuts, because it means that less revenue will be needed in the future to fund interest payments.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, February 28, 2000.


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