(FORTUNE Magazine) – With an extra-large rate hike last month, Fed Chairman Alan Greenspan is trying to pull off some delicate maneuvering. Economists are watching to see whether the economy will follow his lead and cool to a more sustainable pace (the proverbial soft landing) or whether the higher rates will bring the economy to a screeching halt (the dreaded hard landing). Economists poring over inflation and productivity data for clues are looking in the wrong place. To butcher a Bob Dylan lyric, the answer, my friends, is blowing in the stock market.

Never before has the fate of the economy been so tightly bound with Wall Street. The reason? We're experiencing the wealth effect--on speed. The more we spend, the fatter profits become and the higher stock prices go, encouraging us to pump even more money into the economy.

This has left us in a precarious position: In the short run (at least), the interests of the market and the economy are at odds. Why? Policymakers are frightened that today's growth, if continued unchecked, would ignite runaway inflation. Conversely, investors are freaked out that the recent dip in the stock market augurs horrible things to come. Their greed is blinding them to the long-term payoff of a healthy economy. Says Mark Zandi, RFA Dismal Sciences' chief economist: "If the market remains flat for the next six months, the risk to the economy will be greatly reduced."

Greenspan has tried to rein in the economy and the market with six short-term rate increases since last summer. The most recent, half-percentage-point increase, the largest in five years, boosted short-term rates to their highest levels since 1991.

Finally, the market seems to be responding. The threat that the bubble will burst and drag down the entire economy seems a lot less likely. The story is in the numbers. Nasdaq has lost a third of its value from its peak in March, the dinosaur Dow is down 1.5% over the year, and the Wilshire 5000, the index the Fed watches most closely, is down 7% this year. P/Es, though still hefty by historical standards, are way down too. Nasdaq is trading at a P/E of 124, less than half of where it was at the beginning of the year; the Dow and S&P are down 22% and 9%, respectively, since January. Tech stocks have taken an especially bad beating, says Salomon Smith Barney analyst Jeffrey Warantz. He calculated that on average they're down 46% from their peaks, while the typical stock on the NYSE is down 29%. "Effectively, the average stock is now in a bear market," he says. The bears realize this and finally seem to have stopped growling. Robert Shiller, the Yale finance professor who coined the term "irrational exuberance" and claims to have helped convince Greenspan that there was indeed a bubble, says, "Some air has definitely come out of the market. The mood has definitely changed since the dot-com companies have crumbled."

By all accounts, Greenspan and his colleagues are much more at ease than they were a few months ago. "They're relieved," says David Hale, Zurich Group's chief global economist. "We've had a meaningful correction now that hasn't been destabilizing. Sure, it's been a hard landing for some individual stocks, but overall I think we can say we're having a soft landing." The market drop now makes it easier for the Fed to move forward. Analysts say that the market anticipates Greenspan will lift interest rates from their current levels of 6.5% to 7.25% by the end of the year. Wall Street seems resigned to taking its bitter pill--all financial markets, from bonds to futures, have built this expectation into trading levels.

Greenspan is working from the same playbook he used in 1994, when the then-fragile two-year-old expansion looked as though it would trigger inflation. Even before he saw any hard evidence, Greenspan moved quickly, doubling the Fed funds rate, from 3% in February 1994 to 6% in less than a year. "It was widely accepted in the market that a 3% Fed funds rate was unsustainable," says Susan Phillips, a Fed governor at the time and now dean of the business school at George Washington University. "At first there were big gyrations in bonds, while equities didn't do much, but then the adjustment was orderly." The Fed's strategy paid off: Inflation never took hold, and stocks, after a flat year, racked up five years of impressive returns.

The market is a lot higher today than it was in 1994, which makes engineering a similar slowdown trickier. But there's something new at work that should please investors. Productivity growth, already exceptionally strong, should continue to boost profit growth and stock prices, particularly in the tech sector. While higher interest rates are keeping a lid on stock prices, productivity provides a floor under the market. In the short run the market will likely languish as these two opposing forces battle. Ultimately rate hikes will end, and productivity growth should continue, propelling the economy forward. Six months of market stagnation is a small price to pay for a healthy economy and another several years of stock-price highs.