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Investors should sit tight
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May 18, 1999: 4:48 p.m. ET
Experts say sustained inflation, Fed's shift in monetary policy are not a major threat
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NEW YORK (CNNfn) - The Federal Reserve's decision to leave the door open for interest rate hikes later this year left equity markets on shaky ground Tuesday, but market experts said long-term investors should not start shuffling their portfolios just yet.
"Unless you are the sort of investor who likes to chase every wiggle, which is probably not an optimal strategy anyway, you should stay where you are," said Bob DiClemente, chief U.S. economist for Salomon Smith Barney. "Anything the Fed does here ultimately has the purpose of providing for greater stability."
The Federal Open Market Committee -- the policy-making arm of the central bank -- Tuesday left short-term interest rates unchanged at 4.75 percent. However, in a departure from previous announcements on interest rates, the FOMC announced a shift in its bias from "neutral" to "tighten," leaving the door wide open for a possible rate hike later this year.
Higher rates normally hurt stocks
The Fed adjusts short-term interest rates to keep the economy from overheating, or from cooling-off too much. In this case, a rate hike would serve to ward off the threat of inflation by making it more expensive to borrow money. However, a rate hike is generally bad for stock markets because it reduces corporate profits and makes bond markets more attractive.
For now, though, DiClemente, said the change in the Fed's bias is nothing to fear.
"A tightening [or tightening bias] is not meant to be punishing," he said. "It's meant to be a stabilizing force. I think long-term investors should not be afraid of, or wary of, tightening. These types of episodes are almost always stabilizing."
For example, DiClemente said the Fed was faced with a similar economic scenario in 1994. It started the year with "very easy posture and a low 3 percent interest rate, but began to tighten" to stunt the growth off inflationary pressures, he said.
The move admittedly shook the bond market significantly, and gave equities a temporary scare, he said, but both rebounded shortly thereafter and rates again began to drop.
Had the Fed not acted aggressively, DiClemented said the economy could easily have slipped into recession in the intervening years.
"By 1995 we were back in a very clear upward environment and inflation was falling," he said. "The [Fed's] efforts proved very successful."
Stay the course
Stan Shipley, senior economist for Merrill Lynch, agrees that investors considering the traditional risk-reduction strategy of moving money from stocks to bonds should resist such knee-jerk reactions.
"Remain as you are," he advised. "Stay the course."
Signs that the economy is entering a pattern of slower growth, most recently a downturn in new home sales and higher-than-expected jobless claims, began to appear almost six months ago. But Shipley said the economy overall remains healthy.
"[The signs of a slowdown] are going to temper the housing market and some capital investments and it'll temper some of the exuberance [in the equity markets]," he said. "But this isn't going to derail economic growth."
Shipley further noted that inflationary pressures, despite last month's surge in the consumer price index, are not expected to upset the balance of economic stability.
"We just do not think that inflation will remain a problem," he said. "What happened in April was a one-month aberration."
Core inflation, he said, is still down at 1.9 percent year-to-date. That's down from 2.5 percent for the same period last year.
"That tells us that deflation and disinflationary pressures are still quite tense and that inflationary pressures will remain low," Shipley said.
Same goes for gold, a commodity that investors have historically used to hedge against the threat of inflation.
"Why invest in gold?" he said. "You use gold [to offset] inflationary risk and we don't think there's particularly any risk right now."
DiClemente concurs.
The 0.7 percent gain in consumer prices last month, the biggest gain in 8-1/2 years, should serve as "a shot across the bow for anyone who was getting too comfortable with the story that inflation was declining in this high growth economy," he said.
"What this tells us is that inflation is not necessarily headed higher, but that it's going to be very tough to keep it down," he said.
DiClemente added most economists feel that the CPI numbers so far this year have been "a little bit understated" and that April may have been slightly overstated "in an attempt to correct for that."
Looking ahead
If, in fact, the Fed does raise interest rates down the road, Shipley said the Dow Jones industrial average would be hard pressed to hang onto its recent gains.
The blue-chip index, which tumbled to around 10,762 following the Fed's meeting, finished above the 10,800 mark Tuesday.
"The Dow is up there in pretty pricey territory and if the Fed really does pursue policies where rates are going up, that's going to be bad news for [blue-chip] stocks," he said. 
--by staff writer Shelly K. Schwartz
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