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The Greenspan Rally

James Surowiecki
Posted Tuesday, Sept. 8, 1998, at 6:07 PM ET

And Greenspan spoke, and the world was new.

Federal Reserve Chairman Alan Greenspan's oblique comment in a speech Friday night that the Fed's bias was now toward easing interest rates sent overseas stock markets higher Monday and Tuesday, and sparked today's huge rally on Wall Street. The Dow was up more than 4 percent, while the Nasdaq added more than 5 percent. Last week's 500-point decline now appears as only a vague memory, the product of a time when corporate earnings growth was shrinking, Russia was on the verge of imploding, Japan was sinking further into recession, Hong Kong had abandoned the free market, and Latin America's debt load was looking increasingly risky.

Today, of course, well . . . Russia is about to enter a period of hyperinflation, Latin America is struggling to free itself from the effects of emerging-market contagion, Japan meanders, Hong Kong still owns something like a tenth of the country's equities, and corporate earnings downgrades proceed apace. No wonder everyone feels better.

Still, if nothing has really changed, Greenspan's speech was important in a couple of specific ways. First, if the Fed does lower interest rates in the near future, it will ease some of the pressure on weaker foreign currencies. Last week, one brokerage-house analyst said the real question about East Asia was whether the Fed would ease before the Chinese were forced to devalue the yuan. Chinese devaluation could be cataclysmic, and insofar as Greenspan's comments pushed that cataclysm further into the future, they merited some positive reaction. Second, the flat yield curve of the bond market--which means simply that long-term interest rates were almost equal to short-term interest rates--had been signaling deflationary pressures for a while now, and Greenspan's public recognition of those pressures was bound to be welcomed by an increasingly nervous market.

Still the "What's really changed?" question is an important one. One thing to keep in mind is that what the Fed actually does is target the federal funds interest rate (the rate that banks charge each other to lend money overnight), and the market has pushed that rate below the Fed's current 5.5 percent target for a while now. Even if the Fed does lower its target to 5.25 percent (with U.S. unemployment as low as it is, anything more than a quarter-point cut is unlikely), the material impact of the reduction could be quite small. At the same time, Greenspan's speech Friday was cold comfort to those bulls who have been saying that the U.S. economy is so big that it will be able to shrug off these global problems. The whole point of what Greenspan was saying, in fact, was that U.S. prosperity is not, in the long run, independent of the world economy as a whole. He didn't actually say, "I am now central banker of the world," but there was at least a trace of that sentiment in his speech.

The paradox of today's rally, then, is that the stock market rebounded because Greenspan said the Fed might lower interest rates, but Greenspan said the Fed might lower interest rates because the world's economy is in serious trouble. The United States is still in good shape (though U.S. companies' profit margins are not). But if there was ever a good-news/bad-news forecast for investors, Friday's speech was it.