NCPA - National Center for Policy Analysis

The Fed Hit Its Target, Pushing The Stock Market Down

March 26, 2001

When the Federal Reserve first raised interest rates in mid-1999, it was concerned about the stock market being too high -- emphasizing the so-called wealth effect. According to this theory, as individuals' wealth rises, they spend more. The Fed believed the stock market run-up would lead to excessive spending -- setting off inflation.

In short, the Fed said it was targeting the stock market in order to bring it down.

As recent Fed data demonstrate, it got its wish.

  • Last year, the total value of corporate equities owned by households fell $2.5 trillion or 17.6 percent.
  • Of this, the vast bulk -- $2.2 trillion -- was shares owned directly.
  • The value of these investments fell an astonishing 33 percent.
  • By contrast, the value of shares owned indirectly, such as mutual funds or pension funds, fell only $300 billion or 6 percent.

The vast bulk of the market's rise in 1999 was in the NASDAQ market.

  • At the end of 1998, the NASDAQ was worth $2.6 trillion, a significant but not extraordinary increase over its $1.8 trillion level a year earlier.
  • But in 1999, the NASDAQ exploded, doubling to $5.2 trillion.
  • The NYSE also rose, but much more modestly in percentage terms (see figure).

The Y2K problem distorted the NASDAQ. Companies invested large sums in upgrading their computer systems, giving a one-time boost to many computer equipment manufacturers. Instead of letting stocks fall by themselves, the Fed hiked interest rates, pushing the markets down farther than they would have gone.

Now we are suffering from a negative wealth effect, as consumers scale back consumption as their wealth declines.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, March 26, 2001.

 

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