Some Thoughts on Fed Policy and “Policy Mistakes” As We Start Talking About Tapering

by cbus20122

For the people out there who follow the macro environment, there is always a lot of discussion in past market bursts (such as 2008 or 2000) that there are or were fed policy mistakes that either caused or contributed to the meltdown.

This is relevant now because as we come into talks about tapering, there is a lot of chatter about a potential fed policy mistake one way or another.

But I think this is a poor way to think about these items, and views of mistakes completely ignore the context of the macro environment and why the fed made the supposed mistakes in the first place.

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Most Policy Mistakes Are Fed Decisions Where They’re Forced To Choose Between Two Bad Choices

Fed Policy Quick History: Caught Between Tough Choices

Lets start with a quick history of important fed decisions, many which have been labeled policy errors in the past.

  • 1980-1982 Volcker Rate Shock: This was the worst recession the USA had since the GFC, and capped off an era where Inflation was the boogeyman and there were multiple bad recessions and employment shocks. At this time, inflation was running extremely hot (over 10%), and it was starting to get out of control.
    • The Fed’s Dilemma: Raising interest rates would kill the economy, which was already having a tough time dealing with the inflation of the time. Rates would have to rise to 18%, which would seriously cut off lending growth. But it would effectively stem the tide of inflation. Volcker chose the very tough decision to raise rates to 18%, which effectively cut inflation down significantly.
      Another point worth making is that the introduction of Reagonomics was a key factor in reversing the age of inflation of the 1970’s, where there was a significant lack of investment in new productive capacity. At the time, this was extremely beneficial. OF course, we’re more or less at the opposite end of that spectrum right now where we have a glut of overinvestment and have possibly taken the 80’s policies too far (obviously subject to political debate and views).
  • 1998 LTCM Bailout: This was a historic bailout that occurred during a time of a lot of international market turmoil (Asian financial crisis + Russian default) and a burgeoning US equity bubble (dotcom bubble was starting to really pick up steam here). The sudden failure of LTCM however threatened systemic issues in the financial system, and thus became the first bailout of a private hedge fund by the FED. This was a new precedent, and many believe it kickstarted the parabolic phase of the dotcom bubble.
    • The Fed’s Dilemma: Do you allow the LTCM meltdown to spill into the rest of the US banking system and economy, or do you bail out LTCM and support the economy + job growth? The fed chose the latter, which at the time supported their mandate of stable prices and full employment. They did not have a crystal ball suggesting an even greater equity bubble would form from this.
  • 2000-2003 Dotcom Bubble Burst: After likely contributing to the dotcom bubble with the LTCM bailout and interest rate decrease, inflation started to rise a bit in late 1999, and credit growth and equity mania forced the Fed’s hand to cap the bubble before it became even more difficult to control. The fed did a few emergency rate hikes, and the credit cycle quickly turned down, which had been feeding the dotcom mania.
    • The Fed’s Dilemma: Critics of the fed would have said that the emergency rate hike burst the bubble. Critics of the fed also said that they let the bubble get out of hand. Literally, there was no good choice here except to bite the bullet and hope the landing wasn’t too hard. In reality, the real economy did have a soft landing in the dotcom bubble, partially thanks to the fed’s interest rate decrease after the bubble really started to get going.
  • 2007-2008 GFC: After dropping interest rates to keep the economy afloat during the GFC, very few people wanted anything to do with equities, especially tech stocks. This caused a shift in behavior towards real estate, which was already quite strong and resilient even during the dotcom crash. At the same time, the global economy was recovering from the crises of the late 90’s and dotcom era, the euro was being adopted as a currency, and China was rising as a member of the world trade organization. All of the above created a perfect storm for US real estate getting piled into via carry trades, while the US Dollar was getting depreciated by all the above factors.
    • The Fed’s Dilemma: The fed clearly started to see the monster that was being created in 2005. Not only was credit growth going parabolic + real estate lending going off the charts, but inflation was also surging in the USA due to all the aforementioned factors. Gas prices surged to over 4$ per gallon (at a time when many drove “clunkers”), Copper surged to very high prices, and real estate / rent was also going parabolic. Greenspan was looking into a surge in inflation that hadn’t been seen since the 70’s, and was forced to decide between allowing real estate and inflation to go completely unchecked, or to raise rates very quickly to stem the flows from getting more and more out of hand.
      He chose the latter of raising rates, which then led to the chain reaction causing the GFC. Thing is, we don’t know how much worse things may have gotten if Greenspan chose to not raise rates. Think of how much larger the US real estate bubble would have become if it wasn’t cut off at the source. As bad as things got in 2008, they could have been worse if they allowed things to continue.
  • Post GFC Environment: After the GFC, the Fed shifted stance and most central banks became far more accomodative. The reaction of policymakers to any asset drawdowns has become far quicker and far larger. With that said, there have been some scares where the fed was tightening a little bit, which threatened to choke off the economy. The most noteworthy one was in late 2018, where the rate hikes and QE Rollback caused a 20% drop in markets before the fed reversed policy to engineer the 2019 rebound. This was likely a close call in some regards.

Lessons and Takeaways

From all the above, there are a few important lessons for investors when it comes to understanding equity and credit cycles + risk in the macro economy.

  1. The party likely will or can continue so long as the central bank / government are accomodative: You’ll notice that all of the above recessions occurred during a time when the central banks were forced to tighten financial conditions.
  2. Inflation (asset inflation or economic inflation) is always what takes the punch bowl away: So what causes the fed or government to reverse accommodative policy? Almost always inflation. With a mandate to maintain stable prices and employment, inflation in the real economy tends to damage consumer’s wallet and destabilizes prices. Inflation in assets typically comes with credit expansion, and threatens to destabilize employment and prices as it becomes larger and increasingly more fragile. These items generally tie the central banks’ hands and force them into tough decisions. The levels at which the fed is forced to take away the punch bowl however is a lot more subject to opinion, and definitely not precise however.
  3. Raising rates or tightening policy into an overleveraged environment creates systemic risk: If you note the difference between the 1980’s rate increase from Volcker, and the interest rate increases from the GFC or even in 2018, you’ll notice how much more sensitive the economy is to rising rates. And furthermore, you’ll likely realize how much more convex the downside gets with the more debt that exists in a system.
  4. Debt in a system puts a soft cap on long term inflation rates: Because central banks tend to get forced into action when inflation rears its head, and because the central bank behavior causes debt defaults and credit issues to arise, this forms something of a natural soft ceiling on how high both inflation as well as interest rates will go before triggering a deflationary shock. Once again, this isn’t any set level, but you get a good broad view of this by looking at long term interest rates since the 80’s, and then looking at aggregate leverage / credit.
  5. The fed shifting to less accomodative stances isn’t consistent with timing of market selloffs or recessions: If you’re trying to time the market based off this alone, you may get it right some times, but other times you would be far off. This timed the top of the dotcom bubble, but also missed out on the top of the GFC by over two years and quite a few rate hikes. It also missed out on most of the gains in 2017 and 2018 despite rising rates.
  6. The fed doesn’t make “mistakes”, they make choices to deal with the problem at hand over the problems that may occur in the future: In nearly every situation, the fed’s dilemma caused them to choose between dealing with the problem that is currently occurring in the market with the risk that their solution could cause a problem somewhere else down the road. In every instance, the fed chooses to deal with the current problem over the problem that may be. And most people would not do anything different, because we don’t have crystal balls and can’t predict the future. I do think the fed has made bad choices, but most of the choices actually fit their mandate. In other words, don’t hate the player, hate the game.

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