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Wednesday, January 19, 2000

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Money


Stock prices will drive interest rates

S. Balakrishnan

MR. ALAN Greenspan's speech last Thursday to the Economics Club in New York has clearly shortened the odds for a 25 bps rate rise at the next meeting of the US Federal Reserve in February. The Fed Chairman worried about the excessive buoyancy in consumer spending, sparked off by the newly-created wealth in the stock market.

The inflation numbers tell a different story. Both the PPI and CPI indices continue to be well-behaved. Confounded by persistently tame inflation amidst strong growth and low unemployment, the monetary hawks are now shifting gears and saying that the dow nside risk in not raising rates is much more than that of staying put.

Mr. Greenspan seems to be concurring with this view. He has more or less explicitly announced a serial rate rise till the stock market and economy cool down. Given the benign inflation picture, he is much more likely to act in steps of 25 bps than with h arsh one-off measures. He will want bond yields to rise to dampen expectations and increase the discounting of future earnings, leading to a gentle deflation of the stock market. The irony here is that the bond market will do this job too well if the Fed is perceived to be behind the curve: preemptive moves are actually good news for bonds.

Obviously, not even the most hawkish central banker has the appetite for a stock market crash. Capitalism survives on confidence which, once destroyed, will not come back easily. Japan is still paying the price for the BoJ's interest rate misadventures o f the late 80s and early 90s to check stock and property prices.

The betting at this stage must be that Mr. Greenspan will achieve his objective of removing the froth from Wall Street without causing a precipitate fall in the market. Not for nothing has he been dubbed the greatest central banker of all times.

We need not go back too far in time for a precedent. Short-term interest rates in the US were doubled swiftly in the course of 1994 and 1995. Growth was hardly dented and the stock market resumed its rally after a brief hiatus. The only casualty was the dollar, which went into a tailspin.

The gargantuan US trade deficit poses a bigger danger than anything else does. Mr. Greenspan must hope that his economy-cooling measures reduce the import-intensity of consumer spending. This will protect the dollar and keep foreign investor interest in US bonds _ so vital to financing the BoP _ alive.

The risk is that a dollar crash will cause a sharp rise in bond yields and provoke a stock market collapse. Another reason, perhaps, for preemptive gentle doses of monetary medicine.

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