In a speech late in 1996, Federal Reserve Chairman Alan Greenspan asked two questions that have worried investors ever since: "How do we know when irrational exuberance has unduly escalated asset values . . . and how do we factor that assessment into monetary policy?"

In other words, he was wondering openly about whether the stock market was overvalued, and if so, whether the Fed should do anything about it.

At the time of the speech, the Fed chairman was concerned that U.S. stock prices were unaccountably high and that a major correction might damage the American economy. Stock prices have soared since then: The Dow Jones industrial average was then hovering around 6500; it closed yesterday at a little above 11,046.

Today, some analysts and investors believe Greenspan and his Fed colleagues are so concerned about the highflying market that they want to raise interest rates to deflate the bubble. Other analysts conclude the opposite, that Fed policymakers won't dare raise rates very much, out of fear that they will cause the bubble to burst and drop the economy into a recession.

Neither group is quite right, according to recent comments by Greenspan and other Fed officials. Fed policymakers have long taken potential reactions in the stock and bond markets, and the potential for overreaction, into consideration as they acted. But the relationship between the Fed and the markets has become more complex as stock prices have headed higher and the bond markets have come to react so instantaneously to Fed actions and pronouncements.

To avoid surprising the markets, Greenspan frequently uses public speaking appearances to send signals to investors about likely Fed actions on interest rates.

In an unusual instance, he recently used his July testimony before two congressional committees to clear up widespread confusion about why Fed officials in June announced that they had adopted a neutral stance toward the possibility of a rate increase in the near future. He explained that while they agreed in June to raise the Fed's target for overnight interest rates to 5 percent from 4.75 percent because of worries about a possible rise in inflation, concern about investor reactions caused officials to signal that they don't plan a series of such increases "in short order." In part, such heightened concern stems from the fact that Greenspan and most Fed officials believe the stock market is overvalued, and worry that their actions could indeed trigger a big correction.

It also reflects their uncertainty about how a sharp drop in stock or bond prices would affect the economy. The huge drop in stock prices in October 1987 had no discernible effect on consumer spending despite the loss of wealth, and thus no effect on the overall economy.

Greenspan and some of his colleagues, however, have attributed part of the extremely strong economic growth of recent years to the "wealth effect" produced by the rising stock market--the possibility that many consumers have been emboldened to spend more because of the increasing value of their stock portfolios, or because they have more cash in hand after selling stocks for big profits, or capital gains. If that's the case, then a steep decline in stock prices might slam the brakes on consumer spending and thereby slow the nation's economic growth.

But recent research by two economists at the New York Federal Reserve Bank, Sydney Ludvigson and Charles Steindel, questions the extent of that connection.

Essentially, they argue that stock wealth is so concentrated at the top among American households that most have few or no stock holdings. While spending growth has been augmented by capital gains on stock, the concentration of ownership suggests that a market decline shouldn't necessarily lead to a large drop in spending.

In testimony last year, Greenspan said the impact of a market correction depends largely on "whether or not you took out debt against" the paper gains. "The real danger exists if there is an awful lot of debt, which, in the event of a significant stock market contraction, then all of a sudden becomes unserviceable," he said.

After Greenspan's 1996 speech, he sent his top staff to work seeking answers to the questions he posed. As with so many issues involving economics, markets and policy, the results underscored the limits of the policymakers' knowledge and power.

In short, Greenspan and the staff concluded that whatever the level of stock prices, there is no way to be sure whether there is a market bubble. And if the Fed can't tell, it can't do anything directly about it until after the bubble bursts. Only then can policymakers be sure there was one, and then all they can do is help pick up the pieces.

Greenspan summed up his views about equity prices in congressional testimony last month. Stock prices are important because they influence both consumer spending and business investment, but "the central bank cannot effectively directly target stock or other asset prices," he said. "Should an asset bubble arise . . . monetary policy properly calibrated can doubtless mitigate at least part of the impact on the economy" when the inevitable correction occurs.

"And, obviously, if we could find a way to prevent or deflate emerging bubbles, we would be better off. But identifying a bubble in the process of inflating may be among the most formidable challenges confronting a central bank, pitting its own assessment of fundamentals against the combined judgment of millions of investors."

One reason for such caution is that policymakers see that when Greenspan first mused about "irrational exuberance" there were strong forces at work that did boost corporate earnings so much that, in retrospect, the Dow at 6500 was not so irrational after all. Those forces were a heightened level of competition, much of it driven by technological innovations, and a sustained high level of business investment that together were beginning to cause an acceleration in the growth of productivity--the amount of goods and services produced for each hour worked.

A widespread sense among business executives that their customers won't accept price increases has forced them to find ways to increase profits by cutting costs--and the surge in productivity has allowed them to do so.

In December 1996 there were hints that this process was underway, which was one reason analysts' estimates of future corporate earnings were so high. That process, as Greenspan said in his recent testimony, is continuing.

"The business and financial community does not as yet appear to sense a pending flattening in this process of increasing productivity growth," he said. "This is certainly the widespread impression imparted by corporate executives. And it is further evidenced by the earnings forecasts of more than a thousand securities analysts who regularly follow [Standard & Poor's] 500 companies on a firm-by-firm basis, which presumably embody what corporate executives are telling them."

But are the corporate executives and the analysts to whom they speak right? Maybe or maybe not, Greenspan cautioned.

"By itself, the interpretation that we are currently enjoying productivity acceleration does not ensure that equity prices are not overextended," he said. "There can be little doubt that if the nation's productivity growth has stepped up, the level of profits and their future potential would be elevated. That prospect has supported higher stock prices.

"The danger is that in these circumstances, an unwarranted, perhaps euphoric, extension of recent developments can drive equity prices to levels that are unsupportable. . . . Such straying above fundamentals could create problems for our economy when the inevitable adjustment occurs."

CAPTION: UNDAUNTED MARKET

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