Sunday, 9 June 2013

Are we really stupid enough to prefer 2006-2010 to 1995-1999?

I have spent the last week seeing investors in the US. there is a huge debate going on in markets at the moment about whether the US Federal reserve should, or will, slow down the pace at which they have been buying Treasuries, and what it might mean for markets. This note is a short update on the previous post I put on this blog - which was intended as a basic aide-memoire for anyone who wanted to understand a little about how the 1994 'bond crash' played out in financial markets. That period being a reference point for what happens when the Fed starts the process of exiting periods of extraordinarily accommodative monetary policy

The chart below shows US jobs and GDP growth through the 1990s. You can clearly see how in 1994/1995 (when the US Federal Reserve increased its target for Fed Funds from 3% to 6% in 12 months), employment growth slowed from around 350k/month to a trough of around 100k/m, and GDP growth slowed from 5% to 1%. Briefly. Now that is a pretty sharp slowdown and is the basis for arguing that the 'bond crash' represented at the very least a poor piece of policy communication on the Fed's part. Let's forget anything else going on in the world, and accept that if the Fed had either done a better job of preparing financial markets for the necessary monetary policy normalisation, or if they had tightened more slowly, the economy's path would have been smoother.

That's all fine. But what I find surprising is that even now, there is a general sense that the Fed should do everything in its power to avoid a repeat. "We remain unconvinced that the eventual tapering of the central bank's asset purchases will trigger a 1994-style bloodbath in the bond market", John Higgins of Capital Economics is quoted as saying in the Sunday Times today.

The sense that is conveyed is twofold. Firstly, that  there is a risk that 'tapering' could be as bad in 2013 or 2014, as raising rates from 3% to 6% was in 1994. And secondly, that the crash was so disastrous everything that can possible be done to avoid a repeat, should be - despite what we have learnt since.

Here is GDP and employment (and Fed Funds) in the period of the last policy tightening that started in mid-2004. This time, rates increased from 1% to 5.25% in 2 years. The start of the process still saw employment growth slow to 100k/m, but GDP growth held up much better  - until the end of the move. Then, of course, after the Fed had finished raising rates, everything went very, very badly wrong.

So I will concede that 1994 could have gone better. In particular, If the Fed had worked harder on communication, the markets would have been less surprised when the first rate hike was announced. But, the economy didn't slide back into recession and 1995 to 1999 was simply a very good period for the US economy. This, overall, was no disaster.

The 2004-2006 rate hike cycle by contrast, allowed asset prices to go on rising far too fast, for far too long. Allowed leverage to increase throughout the US and global economies. Again, this is not the place to argue against the general view that the great Crash was mostly caused by greed, and poor regulation. But just as Fed policy caused a slowdown in 1995, Fed policy helped cause a massive recession. So the exit from the last two significant periods of very easy monetary policy both have faults - but are we really supposed to err on the side of a 2004-2006 outcome because we must, at all costs, avoid a repeat of 1994-1995? . But are we that stupid? Employment growth running at 170k/m, and GDP at 2% justify accommodative policy, but not zero rates and massive bond purchases for ever.

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