Fed Policy and the Effects of a Stock Market Crash on the Economy - Federal Reserve Board unable to offset effects of market crash

Business Economics, April, 2000 by Ray C. Fair

IS THE FED TIGHTENING TOO LITTLE AND TOO LATE?

Businesses face the risk at the current time of a stock market crash. Profits will undoubtedly suffer if there is a crash and the economy goes into a recession. This paper shows that unless there has been a huge increase in the long run PE ratio, the current level of stock prices implies an unrealistically large share of profits in GDP in the future. The paper also suggests that the Fed does not have the power to prevent a recession from taking place there is a crash.

A major risk that many, if not most, businesses face at the current time is a possible stock market crash. If there is a crash and the U.S. economy goes into a recession, profits will undoubtedly suffer. An important question to consider is whether the Fed has the power to offset most of the negative effects of a crash on the economy. The results in this article, using a macroeconometric model (to be called the "MC" model), suggest that the Fed does not have this power. The results show that the negative effects from the loss of wealth following a crash dominate the positive effects from the Fed lowering interest rates immediately after the crash, and a significant recession takes place.

This paper uses the MC model to consider three cases. The period examined is 1995:1-2004:4. At the time of this study actual data were available through 1999:2. The model was estimated through 1999:2, and a forecast from the model was made for the 1999:3-2004:4 period. The forecast is based on the assumption of no stock market crash and no further boom. The level of stock prices is assumed to grow from 1999:3 at the historically average rate. The first case, called "Base," consists of the actual data for 1995:1-1999:2 and a forecast for 1999:3-2004:4.

The second case, called "Crash," consists of the actual data for 1995:1-1999:2 and a forecast for 1999:3-2004:4 in which there is assumed to be a stock market crash in 1999:3. The level of stock prices is assumed to fall in 1999:3 to a value consistent with historical experience and then to grow at a historically average rate after that. The Fed is assumed to respond immediately to the crash by lowering the short-term interest rate to three percent and keeping it there. This is the case that shows (according to the model) that the Fed does not have the power to prevent a recession from taking place.

The third case, called "No Boom," consists of a simulation of the model for the entire 1995:1-2004:4 period in which it is assumed that there was no stock market boom. The level of stock prices is assumed to grow at a historically average rate over the entire period. The boom is assumed to be shut off by higher interest rates. Interest rates are raised for this simulation beginning 1995:1.

It will be seen that the loss in output comparing "Crash" to "Base" is about the same as the loss in output comparing "No Boom" to "Base." "No Boom" has less variability than does "Crash." If it had been possible to make a choice between these two cases ahead of time--and if they had been the only two choices--"No Boom" would have been preferred. More will be said about this later.

It is obviously difficult to know how overvalued the stock market is, if it is at all. If it is overvalued, the risk of a crash--and thus the risk of a case like "Crash" occurring--is obviously higher. Before considering the three cases, some simple arithmetic is presented in the next section that suggests that the current level of stock prices has unrealistic macroeconomic implications regarding the future share of profits in GDP. In this sense the stock market appears to be overvalued.

Stock Market Valuation and the Share of Profits in GDP

The major boom in stock prices began in 1995. Between December 31, 1994, and June 30, 1999, the S&P 500 index rose 198.9 percent (an annual rate of 27.5 percent), and capital gains on household financial assets totaled $10.876 trillion. [1]

The S&P 500 index was 1372.71 on June 30, 1999. Earnings [2] corresponding to this index are 41.10 for the four quarters ending June 30, 1999, which gives a PE ratio of 33.4. A PE ratio of 33.4 is historically very high. Robert Shiller's web site, http://www.econ.yale.edu/[sim]shiller, contains monthly estimates of the S&P 500 PE ratio for the period January 1871-December 1998, and these estimates reveal how high the current PE ratio is. The largest PE value over the entire period prior to 1991 is 26.6 in January 1895. For the 1,452 months between January 1871 and December 1990, only 52 months (3.6 percent) have a PE ratio greater than 20. The average PE ratio over the whole period of the Shiller data (through December 1998) is 14.2. The average for the period since January 1952 is 15.1.

In order to examine the implications of the current level of stock prices on the future share of profits in GDP, one first needs an estimate of the future growth rate of earnings that is implicit in a PE ratio of 33.4. This will he done using the following formula: