Message to U.S Economy: Don’t Fight the Fed!
The Federal Reserve (Fed) has held the Federal funds rate just above 0% since late 2008, and initiated three rounds of Quantitative Easing (QE) over the last 5 years in an attempt to ignite a self sustaining recovery. Despite unprecedented monetary accommodation this recovery has been far weaker than the average of the 10 post World War II recoveries. Clearly the economy is fighting the Fed. The lack of a stronger economic response to the Fed’s efforts introduces an interesting topic for debate.
As far as Wall Street folklore goes, ‘Don’t fight the Fed‘ may be the most accepted piece of Wall Street wisdom, popularized by Marty Zweig in his 1986 book “Winning on Wall Street“. Historically, there is no question that monetary policy has had a significant effect on the stock market over the last 60 years. The stock market has usually begun a new bull market after the Fed lowered rates, often gaining 30% to 50% in the first year. More importantly, monetary policy has been the most effective policy tool in managing the economy. In times of strong growth and rising inflation, the Fed has raised rates to slow the economy and bring inflation down. To lift the economy out of recession and spur growth, the Fed has lowered rates. For most of the past 60 years, the economy has responded within 6 months or so whenever the Fed has either eased or tightened policy.
The legitimacy of ‘Don’t fight the Fed‘ has been a strong rebound in the economy which validated the run up in stock values. We are concerned that investors are too focused on the positive impact of QE3 on stock prices and are overlooking how important it is that equity valuations be validated by the economy. A quick review of how effective monetary policy has been in managing the economy since 1954 will reveal that monetary policy has indeed lost some of its economic Mojo.
We will divide the period from 1954 to 2013 into two charts. Recessions or periods of pronounced slowing in GDP growth occurred in 1954, 1958, 1961, 1969-1970, 1973-1974, 1980, and 1982 were all preceded by a significant increase in the federal funds rate. Higher interest rates weighed on housing and auto sales, since they are the most sensitive to the higher cost of financing. Once tighter credit and higher rates caused a recession to develop, the Federal Reserve lowered interest rates. The decline in the cost of financing unleashed pent up demand for home and auto purchases, resulting in a strong rebound in GDP growth. GDP jumped to at least 6% in at least one quarter during the initial phase of each recovery. In a number of instances, GDP growth exceeded 8%. The strong rebound allowed all the jobs lost during the prior recession to be recovered within 24 months.
In 1981, the federal funds rate peaked just below 20%, which broke the back of inflation and ushered in an extended period of disinflation. GDP growth exceeded 7% in 1983, but each subsequent recovery has been progressively weaker, even though interest rates have steadily declined. Each period of slowing or recession since 1981 has followed only modest increases in the federal funds rate. The economy has been less capable of handling even a modest increase in the cost of financing and required an ever larger dose of monetary accommodation. Between 2001 and 2003, the Federal Reserve was forced to push the real federal funds rate into negative territory for the first time ever. GDP growth didn’t exceed 2% until the tax cut in the spring of 2003 provided the spark the economy needed to lift GDP above 4.0% in early 2004. Although the Fed increased the federal funds rate from 1.0% in mid 2004 to 5.25% in 2006, the Federal Reserve never really tightened policy. The availability of money for mortgages was plentiful, and credit spreads continued to narrow until mid 2007.
Since the financial crisis in 2008 the connectedness between monetary policy and the economy has clearly further diminished. The Fed’s most powerful tool has always been raising and lowering interest rates. Since 2008, the Fed has kept the federal funds rate just above 0%, which means real rates have been negative for 5 years. When this failed to stabilize the economy in 2008, the Federal Reserve was forced to implement a non-traditional monetary tool in the form of Quantitative Easing. The goal of this extreme measure was to establish a self sustaining recovery. When Quantitative Easing didn’t get the job done, and GDP growth began to slow in 2010, the Fed launched round two of quantitative easing, which required the label QE2. As the European sovereign debt crisis erupted the Fed launched QE3, and then expanded QE3 from $45 billion of monthly bond purchases to $85 billion to offset the expected drag from a tightening of fiscal policy in 2013. Monetary policy has been pushed into uncharted territory and still a self sustaining recovery is not in place.