- The Washington Times - Sunday, March 26, 2000

Alan Greenspan and his Federal Reserve associates on Tuesday pulled the lever again for tightening monetary policy. For the fifth time since June, the Fed raised its federal funds rate a quarter percentage point to 6 percent.

The Fed said in a statement that it moved to raise rates because "economic conditions and considerations addressed by the committee are essentially the same as when the committee met in February." The Fed added that strong demand could trigger inflationary pressures if it continues to exceed supply. Inflationary imbalances would "undermine the economy's record economic expansion."

Interestingly, the Fed made no mention in its statement of one of the more controversial protagonists of the new economy. The stock market has continued climbing to precipitous heights, creating new wealth in America. That "wealth effect" is fueling the demand that the Fed is concerned about. Technological innovations and new sources of labor have helped supply keep pace with demand and have led economists to redefine sustainable unemployment and growth levels. But the Fed is concerned that demand is growing too feverishly for supply to keep up.

So the Fed has systematically raised rates in its efforts to temper market exuberance. But bullishness refuses to be reigned in. Over 12 months, the Dow is up about 13 percent while the Nasdaq has surged a heady 112 percent. More surprisingly, the Fed's monetary tightening hasn't brought down bond prices. On Tuesday, the 30-year Treasury bond climbed 14/32 point, pushing down the yield to 5.97 percent. And although the rates on 30-year mortgages are up for the year, the current average of 8.24 percent is down from 8.38 percent on Feb. 18.

Part of the reason markets continue to climb is that the Fed has raised interest rates in prudently small increments. Stock and bond markets rallied on Tuesday, for example, after the Fed raised rates by a quarter percentage point rather than a half. But if demand generated by stock market wealth is Mr. Greenspan's main concern he should consider using a more precise instrument to rein in exuberance when the Fed meets next time in May.

Raising the margin required to buy stocks, which has been at 50 percent since 1974, could dampen demand for stocks, which in turn could help bring down prices. In this area the Fed should also proceed cautiously. Some experts recommend the Fed should raise the margin to 100 percent. If the margin is raised that much all at once, however, some investors could be forced to sell shares to cover margin calls and that could cause a too rapid decline in equity prices. Boosting the margin requirement to 70 percent initially could be a more cautious approach.

Mr. Greenspan is right in trying to quell market exuberance. Many equity valuations have no logical relation to the company's current or projected earnings. If the floor falls from under some of these stocks and triggers an exodus from the market, consumer demand could plummet and cause a recession.

The inflation outlook, meanwhile, is currently mixed. The Consumer Price Index (CPI) for February indicated some price inflation could be emerging, with 12-month CPI running at 3.2 percent. Although much of that price pressure is due to volatile oil prices, it is unclear just when those prices will start declining. Strong growth, on the other hand, has failed to generate upward pressure on wages. According to last month's numbers, real hourly earnings dropped 0.5 percent. With this uncertain outlook, some degree of monetary tightness may be in order. But the Fed shouldn't depend on increases in interest rates to bridle market euphoria. Interest rates could begin having an illogical relation to inflation data if the Fed continues to raise them.

The Fed, therefore, should use that other lever at its disposal in May. If the Fed continues to increase interest rates primarily to tame the Dow and other indexes, it could unnecessarily slow the economy's growth potential.

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