The Fed is on the verge of repeating history: Morning Brief

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Thursday, March 17, 2022

The Federal Reserve finally took the plunge and raised rates. As expected, Fed Chair Jerome Powell led the Federal Open Market Committee to raise its benchmark interest rate target by 25 basis points.

The Fed famously operates according to two mandates (actually it has three by law): price stability and maximum employment. How the Fed achieves these goals is up to Powell & Co. but if past is prologue, there could be trouble brewing as the Fed amps up its hawkishness.

In the modern era, the Fed has developed a bewildering array of tools: interest-rate targeting, forward guidance, interest on excess reserves, repo facilities, quantitative easing, and quantitative tightening, to name a few. Not to mention any number of emergency facilities to be conjured up and deployed with the Treasury in troubled times.

This wasn’t always the case. When inflation was skyrocketing just over four decades ago, Paul Volcker was elected Fed chairman in 1979 with a mandate to crush high prices. The consumer price index (CPI) reached a high of 14.8% in 1980, before his inflation-fighting efforts took effect.

Prior to Volcker, the Fed targeted short-term interest rates to manipulate the money supply to juice or put the brakes on the economy. Without wading too far in the weeds, the Volcker-era Fed targeted the actual money supply. This and other changes persisted mostly into the end of the 1980s — even after Alan Greenspan became chair in 1987.

But Greenspan pivoted and developed his own style in the 1990s, returning to interest rate targeting and instituting “insurance” cuts to get ahead of various crises — including the 1998 bailout of hedge fund Long Term Capital Management (LTCM), orchestrated by the Federal Reserve Bank of New York.

In fact, the Fed had raised rates a year before the beleaguered LTCM became a systemic risk. This made the 1997 single-rate hike the shortest rate-hiking cycle — if you can even call it a cycle — in the modern era. Its short duration is probably why the 38.5% stock market rally over the following year was by far the best among four other tightening cycles (see chart below). The other post-rate hike periods averaged gains of 5.9%, with the year following the 1994 increase barely eking out a 0.1% return.

The bias toward easing earned Greenspan the nickname “Easy Al.” After Greenspan popped the late 1990s tech bubble, he would eventually lower rates to 1% in 2003 and keep them there for a year. All this set the stage for the Fed to help fuel a housing bubble — this time concomitant with a huge run-up in commodities prices. WTI crude oil (CL=F) rallied relentlessly, topping out at $150 per barrel. (Sound familiar?)

Ben Bernanke picked up where Greenspan left off, leading the Fed to raise rates a quarter percent 17 times at consecutive Fed meetings.

In late 2007, as central banks around the world worked to reduce leverage in the bloated financial sector, cracks in the financial system turned into gaping holes. Bear Stearns nearly folded in March 2008 and was sold to JPMorgan for a song.

At the time, many thought the worst was over. In the spring and summer of 2008, the Fed began winding down its balance sheet from all the emergency lending programs it had instituted — selling and letting roll off $300 billion in Treasury bills. Markets even started pricing in about 140 basis points worth of rate hikes into the end of 2008. (Sound familiar?)

The failure of Lehman Brothers in September 2008 put those hawkish notions to rest — perhaps an important lesson to remember, as the Fed is now forecasting six more rate hikes this year. Powell even said Wednesday at the presser that balance sheet runoff (quantitative tightening) could come as early as the next Fed meeting in May.

“Do we see balance sheet roll-off? And how aggressive is the Fed going to be with this? … we’re used to the central banks coming in and suppressing volatility, but that’s not going to be the case for the foreseeable future,” said John McClain, portfolio manager at Brandywine Global, on Yahoo Finance Live, expressing concern that the Fed may not be paying attention to the recent volatility in stocks and bonds. “We need to buckle up and understand that enhanced volatility in risk assets and interest rates are going to be here as we’re unwinding unprecedented monetary stimulus [amid] a number of exogenous factors like ongoing war and rampant inflation.”

By Jared Blikre is a reporter focused on the markets on Yahoo Finance Live. Follow him @SPYJared

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