When Greenspan Asks Question, Market Listens

In the late 1980s, Japanese stock and real estate prices had reached incredible heights. By one estimate, Tokyo real estate was worth more than all property in the United States. Then the bubble burst. In 1989 and 1990, Japanese stocks lost nearly half their value. Real estate prices followed. The Japanese economy slipped into recession - from which it may finally be emerging this year.

Now, Federal Reserve chairman Alan Greenspan wants to avoid a similar scenario developing in America. He has rocked financial markets by asking if US equity markets are also displaying "irrational exuberance." Immediately after Mr. Greenspan's comments last Thursday night, world stock markets acted as if his pin had been pointed at them. Prices dived on exchanges from Sydney to London.

In New York, Friday morning was white-knuckle time on Wall Street. The widely watched Dow Jones industrial average tumbled 145 points. But when the market closed, the Dow was down only 55.16, or 0.9 percent, to 6,381.94.

"It was a wild day," says John Burgess, a managing director of Bankers Trust Company's Global Investment Management in New York. "The big question for the market is whether Greenspan is making an intellectual statement or delivering a specific message."

Most economists are convinced that Greenspan was mainly "jawboning" the financial markets - trying to prevent an actual bubble from forming. "He wants to let a little steam out," says Bruce Steinberg, an economist with Merrill Lynch & Co. If so, he may have helped do it. Last week's 140-point slide was the Dow's worst showing since April.

Lyle Gramley, a former Fed governor, says Greenspan's motivation is to prepare the market for the possibility of an interest-rate hike in three or four months.

"If the markets are up another 25 percent or so - and that would be the case if the trend in November continues - the market would be very vulnerable to a major shock," reasons Mr. Gramley, now at the Mortgage Bankers Association in Washington. He anticipates the Fed may have to raise short-term interest rates 0.5 to 0.75 percentage points in the first half of 1997 to keep the economy from growing faster than a 2 percent annual rate after inflation.

A hike in interest rates would catch many Wall Street investors by surprise. Most economists expect the economy to chug its way through 1997 with only 2 to 2.5 percent growth. Many expect lower interest rates, not higher.

"We think interest rates are coming down," says Scott Grannis, a principal at Western Asset in Pasadena, Calif., which manages $25 billion in bonds. Mr. Grannis predicts long-term Treasury bills will be heading closer to 5 percent by December 1997, down from 6.51 percent Friday.

Although Grannis is not forecasting a recession, he expects deflation, or falling consumer prices. He sees the falling price of gold as an indication of future inflation expectations.

Stock market analysts believe Greenspan's comments may have sobered up some investors who have only seen stocks rise.

"Greenspan illustrated the market is overpriced and too euphoric," says Michael Metz, a market commentator at Oppenheimer & Co. in New York. Many investors, he says, were expecting a stock market pullback early next year. But, the new money flowing into large-company funds dried up at the end of November. "With the American market valued at $7 trillion, it takes tens of billions just to keep the market up in the air," Metz says.

Other analysts, however, argue the stock market is not overpriced, especially compared with 1987, when it crashed. When some of them met with Greenspan last week, he merely listened to their views - until his comments Thursday night at the American Enterprise Institute, a Washington think tank.

If Greenspan hadn't rocked the boat, stocks might have had a different type of day on Friday. The Labor Department reported a rise in the November unemployment rate to 5.4 percent from 5.2 percent. Payrolls rose at a moderate pace. Normally, this would be considered bullish on Wall Street as a sign that the pace of the economy is easing.

A slowing economy would discourage any move to tighten interest rates at the Dec. 17 meeting of the Fed's policymaking Open Market Committee.

Wall Street does not expect any change. "I don't think the Fed will be acting for a very long time," says Steinberg. For the Fed to ease rates, the economy would have to slow to a 1 percent growth rate for a few quarters, the Merrill Lynch economist reckons. To tighten, there would have to be a few months of rising employment and higher prices.

Greenspan injected an element of doubt, saying inflation's "future course remains uncertain.... We need to tighten or ease before the need for action is evident." He didn't say when that might be.