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The bad side of a boom
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June 21, 1999: 6:28 a.m. ET
The economy is strong. So why is a bigger paycheck a problem?
By Staff Writer Alex Frew McMillan
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NEW YORK (CNNfn) - There's more in your paycheck, you're spending more, more people are working. The economy is booming. Sounds great.
So why does it seem like every piece of good news for your wallet sends the stock market south? And why does the Fed want to tighten your purse strings? You might have more money to invest and spend, but it's not much use if Wall Street is looking for the life rafts and your mortgage just went up.
"Strictly speaking it's not that the stock market views good news as bad, directly," said Jim O'Sullivan, U.S. economist for J.P. Morgan & Co. But it sure seems like it, when shoppers on a buying spree send the Dow industrials plummeting, like they did in April. And when markets welcome signs the economic growth is slowing with open arms, like they did in June.
Why is that? Sure, larger paychecks and more jobs are good for everyone, but only in moderation.
"Too much of a good thing can be a bad thing," explained William Dudley, chief U.S. economist with Goldman Sachs & Co.
Keeping big bad inflation at bay
The economy is growing fast, around 4 percent a year, and that's good at face value. But not in the long run. Rising wages pump inflation into prices, and more jobs means a shortage of labor.
"It's not that growth is bad. It's that the consequences of that growth can be negative," Dudley said.
A trip to the store can get frustrating when the price of that designer suit you so desperately want starts outstripping your paycheck. And it's even more frustrating when the store isn't able to find the workers it needs, so there's no one around to tell you when it might go on sale.
At the moment, there's little to keep the U.S. economy in check. That's why Federal Reserve Chairman Alan Greenspan pointed to positive news -- worldwide recovery, high employment, strong spending and a roaring stock market -- for forcing what he calls a "pre-emptive" move, leading financial markets to believe that the Fed will almost certainly raise interest rates.
So for now good news brings out the Grinch in the central bank.
"There's an old saying, the Fed's job is to take away the punch bowl right when the party got going," said Bruce Steinberg, chief economist at Merrill Lynch & Co.
Curbing growth is bad for stocks
The Federal Reserve has relied on productivity gains to keep growth in pace and prevent inflation from creeping in. It thinks 3 percent growth for the economy is a more realistic rate.
That's because productivity is growing at 2 percent and the labor force is expanding around 1 percent, O'Sullivan said. So the Fed is widely expected to raise interest rates by a quarter point this summer, and perhaps again this year.
Any interest rate increase is temporary bad news for stocks. Wall Street measures companies' profit projections against current interest rates, what's called the "present value of future earnings." So the higher interest rates are, the lower stock prices go.
But Fed rate increases would be aimed at maintaining long-term growth. So, for the stock market and wages, so it's grin and bear it for the short term.
"It's like the kid doesn't want to take any medicine, but it's good for him," said David Orr, chief economist at First Union Corp. "It's a little medicine now versus a lot of bad medicine later."
Inflation is hard to stamp out once it gets going. If it did, the Fed would have to tighten aggressively and the stock market would drop sharply.
"If there is an inflation threat building, and the Fed doesn't act and inflation starts picking up, instead of (a) 50 basis points [increase] it's 250 basis points," O'Sullivan said.
Increased interest rates might also mean a smaller pay raise as well as a more gradual increase in the value of your investments. But slower may be surer. "In the late 1970s and early 1980s, people were getting 10 percent pay raises," Orr said. "But housing prices were going up 12 to 15 percent, and so were cars."
Those people were losing ground, which isn't the case now, and the Fed wants to keep it that way. "If I'm an average person what I need to think about is my raise in relation to what's happening to prices," he said. So long as wages rise faster than prices, the standard of living is actually going up.
Wages are growing around 3.5 percent, with inflation running around 2 percent, O'Sullivan said. "That real wage gain of 1.5 percent is pretty good by historical standards."
Without curbing inflation, wages could rise precipitously, which would be good news until companies had to pay the bill and turn the boom into a recession. "It could be great for six months for a worker, and then he loses his job," O'Sullivan said.
Effect of one increase not too great
A small interest rate rise isn't likely to have a significant effect on the stock market, economists say. "It's basically designed to lean against the wind a little," Dudley said.
It's most likely to hurt short-term, adjustable-rate mortgages more than anything, and make buying a home a little less attractive.
Steinberg at Merrill Lynch said a quarter-point increase would have "almost no impact whatsoever." But if the Fed has to act again by raising rates, it could start to make a difference. Persistent rate hikes would hurt all stocks with high price-earnings ratios. They can only keep their high valuations if interest rates keep low.
So if rates keep heading up, it'll hurt high-priced technology and drug stocks, he said. Bank stocks and other financial services issues would get hurt because they're interest-rate sensitive. And eventually higher rates find their way home to hurt consumer cyclical stocks, such as companies that make retail goods. Stocks that need to borrow from banks for their expansion would also be hurt.
And, in a way, you're hurt, if you're looking for a massive raise and not too worried about all that productivity gobbledygook. In a way, the Fed is always watching to keep paychecks from getting too big, at least too fast. "That's the dirty little secret that the Fed can't say," Steinberg joked, "that they're there to prevent people from getting paid too much."
Of course you can always be ahead of the economic curve. "Between you and me, you want to be the only one getting the pay raise, and not everyone else," Steinberg said. 
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