Fed Policy Then and Now

December 18th, 2015 6:20 am | by John Jansen |

Excellent article via the FT recounting the parallels between the financial landscape in the late 1990s and today and the differing FOMC response to each. If you enjoy financial history this is excellent read.

Via the FT:

History never repeats, but there are some intriguing parallels between the global macroeconomic environment in 1997 to 1998 and today that may help explain the Federal Reserve’s decision to lift US interest rates this week.

Back then, few at the Fed believed in using monetary policy to restrain excessive risk-taking in the financial markets. Now, it seems, things have changed. How else to explain such different reactions to such similar circumstances?

By the end of 1998, inflation had decelerated to the slowest rate since the second world war; oil prices had collapsed by nearly two-thirds; junk bond yields were soaring; the dollar had gained a fifth against the currencies of America’s trade partners; and countries from Latin America to Russia to East Asia were struggling. Meanwhile, the US jobless rate had dropped to a three-decade low.

Policymakers responded to the confusing, contradictory signals from the strong domestic economy and shuddering financial markets by easing policy — first by refraining from an expected monetary tightening and then by slashing interest rates sharply.

Stock markets soared, encouraging excessive investment at a time when the US economy was already running hot.

“The Fed in 1998 was responding to market developments over and above domestic economic concerns and that contributed to extensions in market valuations,” said Toby Nangle, head of multi-asset allocation at Columbia Threadneedle Investments.

The Fed’s decision to begin “normalising” monetary policy on Wednesday may be an attempt to avoid repeating that experience.

Mark Dow, head of Dow Global Advisors, a hedge fund, and a former economist at the International Monetary Fund, says the Fed is keen on preemptively raising the cost of borrowing as a form of “avalanche patrol” for the financial markets.

Is the Fed overcompensating for mistakes of the past by now lifting rates too early?

Brad Delong, economics professor at the University of California, Berkeley, worries the Fed is too concerned about the inchoate future danger of financial instability and insufficiently worried about the “asymmetry of the zero lower bound”. With interest rates still close to zero, the central bank has few options were its current programme to tip the economy into another recession.

The Fed’s approach is strikingly different from its perspective in the roaring 1990s. While some hawks — most notably Janet Yellen when she was a governor on the Federal Reserve Board — then worried the hot job market would lead to faster inflation, the majority of Fed policymakers were more concerned by the risk of financial crises emanating from emerging markets.

The FOMC held rates steady for much of 1997 and 1998 as part of an uneasy balance between hawks worried about falling unemployment and doves fretting over Asia. Then the crash in oil prices pushed the Russian government into default — an event magnified by the collapse of Long-Term Capital Management, an aggressive hedge fund — which rippled through the financial system.

There are some differences between the end of 1998 and today. America’s job market is weaker, and emerging markets have thus far avoided the kinds of acute crises they experienced in the 1990s.

Moreover, the US financial system is somewhat safer today thanks to the combination of higher capital requirements, stricter risk management, tighter regulations and more invasive supervision. There is a world of difference between the liquidation of a few small unlevered junk bond funds and the collapse of a hedge fund so significant the New York Fed had to bring together the big banks to negotiate a bailout.

Still, the behaviour of inflation, oil, corporate bond spreads, the dollar and unemployment are all remarkably similar now as then.

As was the case nearly 20 years ago, there is a sizeable group of people within the Fed who worry the falling jobless rate will lead to faster wage growth. They were not keen on tightening policy when unemployment was high but, as it rapidly slid to the level deemed “natural”, these policymakers shifted from doves to hawks.

Unlike two decades ago, however, these hawks have been reinforced by policymakers concerned by the consequences of the Fed’s response to the global financial crisis. The US central bank has tried to boost spending by pushing up market valuations with the help of low interest rates and massive doses of quantitative easing, a phenomenon former Fed governor Jeremy Stein has called “reaching for yield”.

Sceptics, Stein most prominent, wonder if the benefits to the economy justified the danger of pumping up stock and bond markets. Once unemployment fell, a new hawkish majority was able to coalesce around the twin goals of financial stability and vigilance against inflation. Among the consequences: a flat stock market, a soaring dollar and sharp price declines on junk-rated debts.

So Fed officials, believing they have learnt the lessons of 1998, now seem to be pursuing roughly the opposite strategy: ignore somnolent inflation and fears over the developing world and instead head off any incipient financial excesses and price pressures.

The sanguine market reaction to the Fed’s interest rate increases suggests investors reckon the Fed may have gotten the balance right — so far, anyway.

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