What did We Learn from Recent Monetary Policy Performance?

A growing chorus of commentators are now issuing warnings about additional Fed tightening in light of the flattening Treasury yield curve. Despite clear evidence that job growth in the U.S. is running well ahead of a sustainable pace, low wage and price inflation, for many suggest no need to firm overnight interest rates. Exhibits A and B, in their critiques, are the last two recessions, both of which were characterized by limited inflationary pressures and yield curve inversion. With today’s tame inflation belying the notion that excesses are building, the argument goes, risk management dictates that yield curve flattening is sufficient grounds to warrant an end or reversal of the Fed’s stepwise tightening program.

A careful review of the dynamics that unfolded, 1998-2000 and 2005-2008, suggests that policy, in those instances, was, if anything, too easy. It is certainly true that yield curve flattening in 1999 arrived amid little wage and price inflation and was followed by recession in 2001. And again, the flattening yield curve in 2006 arrived with little wage and price inflation and was followed by recession in 2008. But both of these recessions had their origins in financial market excesses. Firming of policy in 1999 and 2006 might have somewhat hastened the bursting of the bubbles, but was not the underlying cause of the downturn in either case. Indeed, with the benefit of hindsight it might have been better to have tightened policy more quickly on both occasions.

Following roughly two years of gradual tightening, in summer 2005, yield curve flattening reduced the 10-year federal funds rate spread to close to the same level as today’s spread—roughly 90 basis points. Imagine that Greenspan, in deference to the flattening yield curve, reversed course and began lowering the federal funds rate in pursuit of a steeper yield curve and the easier money policy that it implies. Those of us who believe that monetary policy can deliver powerful effects in the short run would all agree that the U.S. would likely have avoided the onset of recession in 2007 and the U.S. housing boom would have extended its wild ride for a bit longer. But mortgage finance by then had become insane. A policy change that would have postponed the bursting of the U.S. housing bubble, given what we know now, sounds like precisely the wrong medicine for what ailed the U.S. in 2005-2006.

Similarly, the NASDAQ trebled from March 1998 to March 2000. Price to revenues for tech start-ups were infinite, as they had no revenues. The tech wreck imposed deflationary forces on the economy. But how would that have been made better if the Fed had tightened less in 1999 and 2000?

Clearly one of the painful lessons of the past several cycles has to be that low wage and price pressures do not guarantee clear skies ahead. Asset market excesses, not wage and price pressures, were the key drivers of recent U.S. boom/bust cycles. Accommodative monetary policy alongside a hot labor market, recent history suggests, is catnip for asset market investors. And the labor market is unsustainably hot. While we don’t know the exact the natural rate of unemployment, employment has been growing at over 200,000 jobs per month leading unemployment to fall by about ½ a percentage point per year. Financial market conditions, as best we can tell, do not show anything like the excesses of the dot com and housing bubbles, for now. That said, it is painful to re-read the sanguine commentary from most Central bank and mainstream economists about financial risks in the U.S. economy in 2006. What we can say with some confidence is that asset prices are elevated and are now benefitting from the pop for activity that has followed the enactment of a large fiscal stimulus. The risk management strategy discussed by Chairman Powell at Jackson Hole calls for some further tightening to reduce the chances that excesses are building. And Powell noted, as the history of the past several cycles compelled him to, that excesses can come from inflation or from asset markets. In principle, regulatory oversight might be the better tool for addressing potential financial system excesses. At the moment, however, other policy makers are committed to stripping away regulatory restrictions, and the Federal Reserve must use the tools that it has.

In sum, it is painfully naïve to expect that the Fed can end the business cycle. Moreover, in current circumstances, the Fed cannot expect help from other parts of our government as it navigates a course. What the central bank can and should do is to limit the severity of boom/bust swings, ensuring a healthier long run economic trajectory. Given today’s backdrop, announced plans to slowly remove monetary accommodation squares with the Fed’s risk management framework. Wagering that clear skies ahead are guaranteed by low wages and prices, though appealing, is a mistake that played a big role in the Financial Crisis of 2008-2009.