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Greenspan eyes Wall St.
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August 27, 1999: 3:28 p.m. ET
Fed chief: Central banks should heed stocks in determining interest rates
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NEW YORK (CNNfn) - Federal Reserve Chairman Alan Greenspan said Friday that central banks must pay closer attention to what is happening in equity markets when determining interest rates, although he didn't comment directly on whether he thinks U.S. stock prices are overvalued.
Speaking at an annual Fed gathering in Jackson Hole, Wyo., Greenspan warned central bankers that the Fed must keep track of asset prices because more Americans own stocks than ever before. Anticipating potential panics in the stock market, he said, is crucial to incorporate into monetary policy, particularly the wealth effect rising stock prices have on U.S. and other citizens.
"There are important -- but extremely difficult -- questions surrounding the behavior of asset prices and the implications of this behavior for the decisions of households and businesses," the Fed chief said. "Accordingly, we have little choice but to confront the challenges posed by these questions if we are to understand better the effect of changes in balance sheets on the economy and, hence, indirectly, on monetary policy."
Greenspan, responding to a question after his speech, said the central bank would intervene in financial markets to correct a sharp and sudden increase in stock prices, but he acknowledged such increases seldom occur.
"Central banks cannot respond to gradually declining asset prices and we don't respond to gradually rising asset prices," he said.
We do respond to sharply reduced asset prices, which create a seizing up of liquidity in the system," he said.
Mini market sell-off
Greenspan's remarks prompted a mini sell-off on Wall Street as investors interpreted his remarks as a warning that stock prices may be overvalued. Bond prices, too, declined on concern that more interest rate increases may be on the way -- a move that would make borrowing more expenses and indirectly reign in the overzealous stock market. Higher rates make bonds pegged at existing interest-rate levels less attractive on maturity.
"As the value of assets and liabilities have risen relative to income, we have been confronted with the potential for our economies to exhibit larger and perhaps more abrupt responses to changes in factors affecting the balance sheets of households and businesses," Greenspan said.
"As a result, our analytic tools are going to have to increasingly focus on changes in asset values and resulting balance sheet variations if we are to understand these important economic forces," he said. "Central bankers, in particular, are going to have to be able to ascertain how changes in the balance sheets of economic actors influence real economic activity."
Greenspan has previously expressed concern about soaring stock prices, the most famous utterance being his rhetorical "irrational exuberance" remark back in 1996. In Friday's speech, he cited last fall's global financial turmoil following the Asian financial crisis and the Russian default as an example of how asset prices can affect economies.
"That episode of investor fright has largely dissipated," he said. "But left unanswered is the question of why such episodes erupt in the first place."
An academic tone
His remarks were revealing, albeit academic. Greenspan made no specific references to the current state of the economy, the current level of the stock market, or the Fed's collective decision to raise interest rates by a quarter point this past Tuesday. The trend-setting fed funds rate now stands at 5.25 percent.
Part of that stemmed from the notable absence of a major financial crisis. Just as last year's conference began, Russia devalued its ruble, defaulted on its debt and involuntarily initiated a credit-crunch crisis that caused financial markets to seize and the Fed to ease rates three times between September and November. The year before that the Thai baht was on the verge of collapse, brewing what would be a currency crisis in the Far East.
As for interest rates, Greenspan opted to address the extreme macro-economic perspective, using 18th-century England and ancient Rome to explain how efforts to control and maintain interest rates haven't changed all that much over the years, despite vast changes in technology, life expectancy and economic organization. Nor have rates themselves, he said.
British long-term government interest rates ranged from 3 percent to 6 percent from the 18th century to the 20th century. "Indeed, scattered evidence dating back to Rome and before reflects the same order of interest-rate magnitude," Greenspan said.
About 100 people -- mostly central bankers from around the world, including a majority of the Fed's policy-setting Federal Open Market Committee and economists -- are attending the three-day conference. This year's topic is "New Challenges for Monetary Policy." 
-- from staff and wire reports
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