At the beginning of every FOMC meeting, the Federal Reserve's research team provides an analysis of economic growth, inflation trends, and developments in financial markets. Here is a summary of what the Fed staff reported at the December 1999 FOMC meeting, during the peak of the tech bubble. Every financial cycle possesses both unique and shared characteristics, and the example from 25 years ago could be replaced with many contemporary examples. How would policymakers respond today if faced with a similar statement, having experienced two bubbles?
Mr. Michael Prell, Federal Reserve Economist, Statement at the FOMC on December 21, 1999.
That, we fear, is the current situation, with the rising stock market overriding the effects of monetary tightening. Once again in recent weeks, the market has defied our notions of valuation gravity by posting an appreciable further advance. Moreover, it has done so in a way that seems to highlight the risk that it will continue doing so. I refer to the incredible run-up in “tech” and e-commerce stocks, some of which have entered the big-cap realm without ever earning a buck.
To illustrate the speculative character of the market, let me cite an excerpt from a recent IPO prospectus: “We incurred losses of $14.5 million in fiscal 1999 primarily due to expansion of our operations, and we had an accumulated deficit of $15.0 million as of July 31, 1999. We expect to continue to incur significant...expenses, particularly y as a result of expanding our direct sales force…. We do not expect to generate sufficient revenues to achieve profitability and, therefore, we expect to continue to incur net losses for at least the foreseeable future. If we do achieve profitability, we may not be able to sustain it.” Based on these prospects, the VA Linux IPO recorded a first-day price gain of about 700 percent and has a market cap of roughly $9 billion. Not bad for a company that some analysts say has no hold on any significant technology.
The warning language I’ve just read is at least an improvement in disclosure compared to the classic prospectus of the South Sea Bubble era, in which someone offered shares in “A company for carrying on an undertaking of great advantage, but nobody to know what it is.” But, I wonder whether the spirit of the times isn’t becoming similar to that of the earlier period. Among other things, it may be noteworthy that the tech stocks have done so well of late in the face of rising interest rates. Earlier this year, those stocks supposedly were damaged when rates rose, because, people said, quite logically, that the present values of their distant earnings were greatly affected by the rising discount factor. At this point, those same people are abandoning all efforts at fundamental analysis and talking about momentum as the only thing that matters.
If this speculation were occurring on a scale that wasn’t lifting the overall market, it might be of concern only for the distortions in resource allocation it might be causing. But it has in fact been giving rise to significant gains in household wealth and thereby contributing to the rapid growth of consumer demand--something reflected in the internal and external saving imbalances that are much discussed in some circles. Whether our assumed 75 basis point increase in the fed funds rate would be a sufficient shock to halt this financial locomotive is open to question.
Note: Policymakers raised official rates by 100 basis points across the next three meetings, and the tech bubble burst in March 2000. Presently, the Fed is easing policy as equity prices experience a substantial rise. Will the result differ this time?
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