Irrational Effervescence?

A Federal Reserve official leaked to The Wall Street Journal last Monday the news that Fed policymakers, at a March 31 meeting, agreed that an increase in interest rates is more likely than a decrease.

The news sent stock and bond prices plunging sharply.

That, some economists suspect, is just what the Fed wanted. It would like to let some steam out of financial markets and slow the economy a little.

"Having articles like that appears just as useful as tightening policy itself," says David Hale, chief economist at Zurich Kemper Investments in Chicago.

Mr. Hale sees a risk of a "bubble economy" developing in the United States, with prices of stocks and commercial buildings inflated beyond reason by a speculative binge. Already, share prices have bounced back from last Monday's plunge.

"There is a danger of getting [a bubble]," says Paul Kasriel, chief US economist of Northern Trust in Chicago. "By most accounts, stocks are overvalued.... But we aren't in a bubble economy yet."

Fed Chairman Alan Greenspan raised the specter of "irrational exuberance" in the stock market in a December 1996 speech. After a sharp dip, stocks kept going up. So, though, did company profits.

Mr. Greenspan's concern then, and that of some economists now, is that the US could suffer the fate of Japan in the 1980s. Stock and real estate prices there zoomed skyward until December 1989, when the bubble burst.

Japan's economy has been struggling to recover from that mess until today.

Neither Mr. Hale nor Mr. Kasriel see the same extremes in the US as in Japan in the 1980s. But they do see some similarities.

Pressed by the US to reduce its international payments surplus by boosting its economy, Japan pumped up its money supply - the fuel for economic growth. It rose at an 11 to 12 percent annual growth rate in 1988, just a little slower in 1989. Much of that extra money, instead of being invested in productive business activities, merely pushed up prices in the stock market and real estate.

In the US, notes Kasriel, a broad measure of the after-inflation money supply called M-3 (which includes cash, checkable account balances, time deposits, and some other financial assets) rose 10 percent in the past 12 months, and at a 14 percent annual rate in the first quarter. Such rapid growth hasn't happened since 1983.

The output of goods and services usually picks up a few months after such an acceleration in the money supply, Kasriel says.

And output in the US did rise at a 4.2 percent annual rate in the first quarter. That's higher than many economists expected.

Inflation, he adds, follows more rapid money growth after three years. Money picked up two years ago, so he sees modestly more inflation next year.

Hale notes other indicators of a potential bubble: The stocks in the Standard & Poor's 500 index sell for 29 times their one-year earnings, a historically high multiple. Investors are moving money into mutual funds so fast that fund assets will soon exceed those of the banking industry. Home prices are up sharply in New York, San Francisco, Denver, and other cities. Builders plan the largest expansion of commercial buildings since prior to the property bust of the late 1980s.

Economic policymakers, Hale says, are letting a bubble economy emerge "to help Japan and other Asian countries cope with the implosion occurring in their formerly robust financial systems."

But Bruce Steinberg, chief economist of Merrill Lynch & Co. in New York, doesn't see an asset bubble nor expect the Fed to tighten because of stock prices. If job growth is excessive, the Fed will raise rates, he figures.

So far that's not the case, he says. The Fed will watch, not act.