Courtesy of Doug Short.
And This Time Seems To Be No Different
Note from dshort: Franz sent me this on Saturday, as I was driving to the Mountain Song Festival in Brevard, NC. My weekend enjoyment of the best in bluegrass (which included, as expected, a guest appearance by Steve Martin), delayed my posting of this article until after Larry Summers, to the delight of monetary doves, withdrew his name from consideration for the Fed Chair position. The plot thickens! (Or thins?) Regardless of who gets the post, Franz’s study of the historical context of Fed Chair transistions offers fascinating insights.
The race to find a replacement for Ben Bernanke as the next Fed chairman is reaching a climax in a contest unusual to anything that we have seen in a long time. Whoever can recall such a heated debate regarding the appointment in this so powerful position? The stakes are indeed high and everyone seems to have a strong opinion about who should be the next chairman. Larry Summers is depicted as more hawkish, Janet Yellen as more dovish. The sell-off in the bond market lately is often associated with the rising odds of Larry Summers’ appointment. In this heated debate some important points have been lost: That in the past any change in the chair of the Fed was associated with an unusual time of a more tight monetary policy and that this time again the stage has been set for the end of the current extremely expansive monetary policy a long time before anybody mentioned Larry Summers as a possible contender.
There seems to be a clear pattern in the timeline of the past Fed Chairmen in the last decades: The monetary policy during their tenure was mostly rather dovish, but every time they passed the torch to next one, they seemed obliged to bring it back to a more neutral or even hawkish level, a change in course that was often picked up by the next person at the start of his first term, until things became more rocky and he switched back to a more expansive course in the later years. So it seems that Fed chairmen tended to press the pedal to the metal most of the time, but before the captain passed the helm he tried to reduce the speed almost to a stand-still. Not without dangers, as I will show.
Now here is the evidence: I plotted the yield of the Fed Fund rate and the 10-year Treasury together with the changes in the chair of the Federal Reserve and important (negative) events taking place soon after the change:
Let’s start in early 1970. After almost 2 decades at the helm of the Fed (longer than Greenspan and the longest term in the history of a Fed chairman) William McChesney Martin, Jr., ended his term. But before that he started to increase the Fed Funds Rate dramatically. That ended the longest running expansion in US history at that time. (At least since the NBER defined recessions starting with 1854: http://www.nber.org/cycles.html). For almost a decade had the US economy grown; the “roaring 60s” were unlike anything seen before. (Only the 1990s should later top that record). Well, this ended with the 1970 recession that began only 2 months before Martin left the office.
Arthur F. Burns, who followed in his footsteps, is often dismissed for his far-too-easy monetary policy that let to inflation scare in the 1970s. So in this case it is hardly surprising that the end of his tenure, and the change to G. William Miller in 1978, and then to Paul A. Volcker just 18 months later, brought a sharp change in the policy of the Fed, followed by a huge bond crash and the legendary “double-dip” recession. What should nevertheless not be forgotten is that the run-up in the Fed Funds rate already started at the end of Burns term and peaked already in the early Volcker years.
The Volcker years are of course associated with a very tight Fed policy (as sharply opposed to Burns’ term). Nevertheless the early years of Volcker’s rule made his legacy. Interest rates were much more benign in his later years, which led to the booming 80′s and Wall Street’s comeback … until 1987. Briefly before Greenspan took office and the Fed policy would change to a much more expansive tune, Volcker began a series of rate hikes. The bond market didn’t like what it saw. The yield of the 10 year Treasury rose from below 7% to above 10%, a change of more than 300 basis points in less than a year, something that we have not seen since. Just 2 months after Greenspan took office, the bond crash was followed by the big stock crash of 1987 (“Black Monday”).
Greenspan’s legacy nowadays is often associated with bubbles as a result of a too-easy policy. Some see the cause of the financial crises in the extreme low interest rates in 2003. But again, before Greenspan left the Fed, he started a rate hike cycle that brought the Fed Funds from 1% to 5.25% (with the last couple of hikes under Bernanke’s watch), an increase of 425 basis points, the largest increase in the Fed Funds since the early Volcker years, which is remarkable as the Fed chair was passed from one “dove” to another. Well, with hindsight, many would argue that the US experienced a change from a level too low to one too high. And financial crises followed soon.
And now? Bernanke has been often criticized for his “money printing” aka “quantitative easing”. Well, right before he leaves, what does he do? He sets the stage for the end of QE. Once the next chairman (or woman) will take the office, the “taper” is well under way. The new chairman’s first FOMC meeting will be the one on March 18-19, 2014. At this time most market participant expect that the largest part of the reduction in the bond purchases will already have taken place. With the strong connection to the unemployment rate in the Fed communication, the near-term future of the Fed policy is rather well defined. It will take time before Bernanke’s successor will be able to make an impact. Essentially, the future path already been laid out.
What does that mean for the stock market? Nothing good. There has been a strong connection between the Fed Balance Sheet (especially to the securities part of it) and the stock market in since 2009:
If history is any guide, the end of this year should still be good time for the stock market, but next year could get ugly.
And there is not really a way back from where the Fed is heading. The unemployment rate is drifting lower. A turn-around in the taper would be difficult to explain. The stage for the end of QE is set. I can’t really see reasoning for “QE eternal” here:
The falling labor force participation rate is sometimes quoted as a possible reason why the Fed might change the previously defined targets. But as I have explained in 2 posts in the past (US Economy: Below Stall Speed or Already Above Potential? and Forget the Jobless Recovery, Get Ready for the Full-Employed Recession), the falling participation rate is part of a long-term trend of retiring baby boomers. True, there are people leaving the workforce for other reasons than demographics. But that seems to be exaggerated in my opinion. Here is a chart of the participation rate overall and that of the 25-54 year olds (the main cohorts of the workforce), a number not influenced by demographics. As you can see, there are people leaving the work force for non-demographic reasons, but the impact seems to be rather subtle, nothing that explains the sharp fall in the overall rate:
But the much bigger story is the shift in population out of the main cohorts in the workforce (the 25 tp 54 from above) towards the older part of the population that has a much smaller participation rate:
So the shift in the participation rate seems to be a much more general trend, a fact that still has to be acknowledged by many people on Wall Street. It is for that reason that the macro data in general has lagged the forecasts of Wall Street analysts as well as the Fed’s own projections, whereas everything related to the unemployment rate (including initial claims) has in general at the same time surprised on the positive side.
Here is a chart of the initial claims (4-week average), which has fallen to levels that in the past have been seen only during the tops of the business cycle. It’s difficult to argue that the economy has improved in this regard:
In the wake of the Financial Crisis, it is often said that the US economy is now growing much more slowly tha in the past, a sutation often referred as the “new normal”.
I would argue just the opposite: It is due to the slack from the crisis that the economy could grow as fast as it has (even as the growth has been so mediocre). Otherwise the retirement wave would have cut into potential growth a long time ago.
So QE is coming to an end, and there is not much that the new Fed chairman (whoever it will be) can do about it. Whether it will be Summers or Yellen or Kohn or whoever, the new chairman will have to adapt to a different kind of “new normal” — that of a US economy restricted by a tighter labor market, despite low growth.
But coming back to the original point: The later years of the new man or woman at the helm of the Fed may bring a much looser policy again (that’s why I don’t believe that interest rates will rise as fast as the Fed Funds Future contracts currently imply and rather think that the fear of a bond crash is overdone). But the early years will be marked by an unusually tight monetary policy. And that will mean a rocky start for the new guy. But so it has been in the last few decades.
Franz Lischka works as an asset manager in Vienna, Austria.