Economic Report President

971231 980106 980112 980116 980122 980128 980203 980209 980213 980219 980225 980303 980309 980313 980319 980325 980331 980406 980410 980416 980422 980428 980504 980508 980514 980520 980526 Jun 980605 980611 980617 980623 980629 980703 980709 980715 980721 980727 980731 980806 980812 980818 980824 980828 980903 980909 980915 980921 980925 981001 981007 981013 981019 981023 981029 981104 981110 981116 981120 981126 981202 981208 981214 981218 981224 981230Chart 2-6 Equity Prices in 1998Stock markets rose strongly in the first half of 1998, fell sharply between mid-Julyand the end of August, and surged again after early October.Index (12/31/97 = 100)150140130NASDAQ120110100S&P 5009080Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov DecSources: National Association of Securities Dealers Automated Quotations and Standard & Poor's.The striking changes in financial market conditions over the pastyear and a half had—and will continue to have—important effects onreal economic activity in the United States. Before discussing theseeffects, however, it is worth examining in greater detail one type offinancial institution that was hit especially hard by the turmoil of lastyear.NEW CONCERNS ABOUT HEDGE FUNDSIn late September a group of large financial institutions urgentlyinvested $3.5 billion in Long-Term Capital Management (LTCM), aprominent hedge fund, to prevent its imminent collapse. Representativesof these firms—which were already LTCM’s principal creditors—had been encouraged to undertake the rescue by the Federal ReserveBank of New York, which feared that a sudden failure of the fund couldsignificantly disrupt financial markets. The New York Federal ReserveBank did not set the terms of the rescue or invest public money. Nevertheless,the episode prompted serious questions about the economiceffects of hedge funds and appropriate public policy toward them.What Are Hedge Funds?The label “hedge fund” is usually applied to investment companiesthat are unregulated because they restrict participation to a relativelysmall number of wealthy investors. No precise figures are available,but the amount invested in hedge funds as of mid-1998 appears to63