Wednesday, July 16, 2003

Quoth Alan Greenspan yesterday:

On the asset side of the balance sheet, the decline in longer-term interest rates and diminished perceptions of credit risk in recent months have provided a substantial lift to the market value of nearly all major categories of household assets. Most notably, historically low mortgage interest rates have helped to propel a solid advance in the value of the owner-occupied housing stock.

In other words, the rise in housing prices, and hence the housing boom itself, was due to some considerable extent to the Fed's own action of lowering interest rates through the historical floor.

And the lowered rate at which investors discount future business earnings has contributed to the substantial appreciation in broad equity price indexes this year, reversing a portion of their previous declines.

In addition, reflecting growing confidence, households have been shifting the composition of their portfolios in favor of riskier assets. In recent months, equity mutual funds attracted sizable inflows following the redemptions recorded over much of the last year. Moreover, strong inflows to corporate bond funds, particularly those specializing in speculative-grade securities, have provided further evidence of a renewed appetite for risk-taking among retail investors.

In other words, the low interest rates are also the main reason that stock prices are going back up. It's not that people think that prospects for earnings have improved (nor does Greenspan, as we'll see), it's just that saving accounts are looking even worse.

He goes on to praise refinancing, which has given homeowners a shot of discretionary cash by letting them pull equity out of their homes, pay off their other loans, and reduce their payments. To a point:

We expect both equity extraction and lower debt service to continue to provide support for household spending in the period ahead, though the strength of this support is likely to diminish over time.

In other words, to the extent people are spending more, it's because of the lowered interest rates at least as much as they're earning more. And we can't keep on lowering them forever.

In the meantime, how is business responding to the favorable interest rates?

In the past, such reductions in private yields and in the cost of capital faced by firms have been associated with rising capital spending. But as yet there is little evidence that the more accommodative financial environment has materially improved the willingness of top executives to increase capital investment. Corporate executives and boards of directors are seemingly unclear, in the wake of the recent intense focus on corporate behavior, about how an increase in risk-taking on their part would be viewed by shareholders and regulators.

As a result, business leaders have been quite circumspect about embarking on major new investment projects. Moreover, still-ample capacity in some sectors and lingering uncertainty about the strength of prospective final sales have added to the reluctance to expand capital outlays. But should firms begin to perceive that the pickup in demand is durable, they doubtless would be more inclined to increase hiring and production, replenish depleted inventories, and bring new capital on line. These actions in turn would tend to further boost incomes and output.

Isn't that precious? Business activity is going nowhere. But business leaders might change that if they perceive a long-term pickup in demand. And that might, at long last, improve jobs and incomes in America -- unless they do their hiring in China. But his best evidence that businesses might actually ramp up domestic production in the coming months, if you read the full speech, is that "industrial output has stablized" -- that is, that actual business production has (momentarily) ceased to drop.

In summary: by lowering interest rates through the floor, the Fed has gotten people to spend money now, and pump up stock prices to a semblance of their former levels. But that cash infusion won't last forever, and business isn't picking up in the meantime.

The speech had a few more lines like the one I quoted, suggesting that if business decides to give more people jobs (the way they haven't been), then more people will have jobs. It was generally covered as providing a bright, optimistic outlook.


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