After the Stock Plunge: No Bubble Economy

No tears are likely at the Federal Reserve Board over the sharp stock market tumble last week.

When Fed policymakers meet Tuesday in Washington, they are more likely to take reassurance from the stock plunge that the US economy doesn't need its brakes tightened with higher interest rates.

After a soaring summer, the market finally dampened what chairman Alan Greenspan referred to last December as possible "irrational exuberance" on Wall Street.

Mr. Greenspan was speaking of the danger of the United States following in the footsteps of Japan. A huge bubble developed in both stock and real estate prices in the 1980s. When it burst, Japan's economy slumped into a long recession that it is only now lifting.

Stock prices, as measured by the Dow Jones Industrial Average, slipped 6.8 percent over seven trading sessions ending on Friday, when the downturn was climaxed Friday by a 247.37, or more than a 3 percent decline. This is one of the worst daily setbacks in percentage terms in the 1990s.

Wall Street analysts were a little baffled at why investors suddenly shied away from stocks like a spooked horse. The economic news was good - low inflation, moderate growth.

But at the Fed, there has been concern that investors, flush with new paper wealth, might set off an inflationary spending boom.

Fed watchers on Wall Street do not expect the central bank to raise interest rates at its meeting Tuesday, or even at its Sept. 30 session. But there is some suspicion that if the economy continues to thrive, the Fed will eventually raise short-term interest rates.

The Fed, predicts Paul Kasriel, an economist at Northern Trust Co. in Chicago, "will pull back on the fed funds reins" at its Nov. 12 meeting with a rate hike.

Some economists had been concerned that the so-called "wealth effect" - the tendency of investors to spend a small percentage of new stock or other wealth on major purchases - might make the Fed anxious about inflation.

"It could make the economy too strong," says Bill Dudley, economist with Goldman, Sachs & Co., a New York investment house.

With the stock market decline, however, the Fed is considered unlikely to worsen investor fears by raising interest rates Tuesday.

When Mr. Greenspan spoke a few times last winter of the excitement in the market, some financiers criticized him for poking his nose in their affairs. Investors reacted briefly, then ignored the warning, pushing stock prices up further.

Fed officials became silent on the issue.

The market selloff has not erased most investors' paper profits. The Dow remains up 19.3 percent for the year.

Moreover, the selling pressure was primarily on the bigger stocks. Analysts had been cautioning investors that all the money poured into index funds that buy all the stocks in the Standard & Poor's index of 500 stocks had pushed these big companies' stock prices to astronomical levels.

The Russell 2000 index, which is made up of 2,000 companies whose market values are less than those of the top 1,000 companies in the US, was down just 2.9 percent since its peak last week. The Nasdaq composite index was down 4.2 percent. But most of that loss was explained by drops in the value of stocks of a few large companies.

Looking for an explanation of the price "correction," analysts offered several possibilities.

1. The market was shaken by the "double witching" day Friday, when stock option contracts expire. Stock prices often fall on these periodic days.

2. The Fed might put on the brakes. But this was a minority view.

3. Labor has become stronger, with workers demanding a bigger chunk of flowering corporate profits.

There was some speculation on this subject with the strike against the United Parcel Service by the Teamsters Union.

"It could mark a watershed in the bargaining power of labor and the willingness of labor to take a strike to get higher wages," Michael Metz, market strategist at Oppenheimer & Co. in New York told the Associated Press.

4. Corporate profits may grow less vigorously.

Lower earnings warnings from Gillette Co. and Coca-Cola Company helped drag down prices .

As for the economy itself, Fed policymakers will hear extraordinarily good news from staff economists. Producer prices were actually down for their seventh consecutive month in July. Consumer prices were up just slightly.

Retail sales were up 0.6 percent in July, and that, according to Merrill Lynch chief economist Bruce Steinberg, is "consistent with sustainable noninflationary growth."