Ever since the economy got the final bit of really good news — i.e., a boom in employment of 308,000 for the month of March — the bond vigilantes awoke from a four-year slumber and took aim on the fixed-income markets. Not only did bond prices get bashed, so did investors in real-estate investment trusts (REITs) and utilities, as well as many financially related securities, which lost 20 percent of their value in a few days. Housing stocks also took a tumble as fears over rising interest rates translated to higher mortgage rates, default probabilities of floating-rate mortgages, and a slump in new and used home sales. The media was chock full of Alan Greenspan’s testimony before Congress, in which he intimated that interest rates had to go up. The stock market, as measured by the Dow, responded by dropping more than 123 points.
These days, all it takes is a glance from Mr. Federal Reserve to send the markets haywire. After the stock market closed down triple digits, business-media moguls espoused the notion that good times were about to end—rising inflation, rising interest rates, stock market collapse, bankruptcies, etc. But haven’t you heard these gloom and doomers before?
In the old days, when we were slaves to data on the weekly money supply, all the market know-it-alls would rush to the Dow Jones ticker-tape machine on Thursday afternoons, checking if the growth in money measures like M1, M2, or M3 was above the Fed targets. Woe to the markets if that growth rate exceeded the bands set by the Fed.
Few follow money-supply growth rates any more, and the St. Louis Fed no longer draws those strange little trend lines to denote what the “right” rate of money-growth should be. The markets have moved away from the old Milton Friedman “control the money supply” game and on to the next fad—reacting to Greenspan.
Let’s get real folks. Interest rates will go up because the economy will grow and the demand for money will grow, and when the Fed decides that it’s time for short-term interest rates to go up, it will raise the fed funds rate.
Banks are in the business of making loans and when the growing economy triggers a boom in loan demand the banks will accommodate that loan demand. After that, a rising number of loans will create rising bank deposits, which will require increased bank reserves. The Fed will accommodate that increased loan demand at its target interest rate. In other words, the money supply as measured by the monetary base will expand accordingly.
If the Fed decides to lean against the wind, bingo—it will jack up the fed funds rate. The Fed’s role is to accommodate actual loan-demand regardless, and to use the fed funds rate to either moderate or stimulate that demand. But don’t think that when the time comes such increases will curtail growth in reserves—that growth will be determined by the growth in overall loan demand. At the end of the day, the Fed will either provide banks with needed reserves through open-market operations or it will provide them with reserves through the discount window.
What is interesting is that, with a booming economy, business-loan demand is falling, not rising. This is not your father’s traditional economic expansion. Productivity is mitigating the need for bank borrowing. To see this, think about the notion of infinite operating leverage whereby business technology is, in effect, “taking over.” Higher sales-GDP from applications can be considered “pure productivity” that doesn’t tax resources or drive up prices. If Apple Computer sells more songs over the Internet, people are simply downloading more songs at a buck a song. This transaction has neither fixed nor variable expenses and therefore adds to GDP as pure productivity gains. This type of activity increases GDP without price pressure. It’s pure productivity, and it brings into question the entire rationale for expectations that the Fed will be raising interest rates just because GDP is growing (at least until more evidence accumulates of potential labor-market tightness).
In any case, history tells us that when the Fed begins to raise rates, the equity market fears higher rates. However, once the Fed stops raising rates, the party is just beginning. That’s because the Fed only raises rates when it thinks the economy is strong enough to justify higher rates, which implies good times for corporate profits. Remember what the stock market did in the years following the 1993 rate increases? Here’s a reminder:
Once we get through the political turmoil of an election year at home, and the international turmoil related to the war on terrorism, the basic underpinnings of a strong economy and a strong stock market will be intact. The advantages of technology-enhanced productivity and related corporate efficiencies may very well put a lid on inflation and, in the process, keep the Fed from getting too aggressive in raising interest rates.
– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and chief investment officer for Victoria Capital Management, Inc.