The Fed’s Faulty 1937 Excuse
Central bankers aren’t likely to observe financial excesses until it’s too late.
By Christian Broda And Stanley Druckenmiller
Updated April 15, 2015 7:05 p.m. ET
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Policy makers and financial pundits insist that the risk of the Federal Reserve raising rates too early exceeds that of moving too late. The Fed appears to agree. In recent years, the Fed has repeatedly moved its goal posts, seemingly to avoid raising the federal-funds rate from near zero.
But is the prevailing consensus correct if emergency economic conditions are long past?
Comparisons with 1937 or with Japan in the 1990s are commonly used as examples of mistakes to avoid. Both occasions were preceded by a severe financial crisis, and years later monetary policy was prematurely tightened.
The differences between the current policy conjuncture and these historical analogues are striking, however. Eight years after the 1929 crash, consumer prices in the U.S. had fallen by a cumulative 18% and unemployment remained above 14%. And in Japan today prices are still down relative to their pre-banking crisis levels.
In contrast, since 2007, prices in the U.S. rose by an accumulated 16%, and the Fed’s favorite annual inflation measure has never been below 1%. Current unemployment is at 5.5%, the same rate prevailing in the boom years of 1996 and 2004. The U.S. is currently far from being mired in deflation and low growth as was the case in the late 1930s or in Japan in the 1990s.
Therefore the initial conditions for considering the conduct of future monetary policy are radically different.
Another aspect of 1937 and Japan’s crisis is also being overlooked. In 1937 U.S. household net worth and the stock market were significantly lower than their 1929 levels. Similarly in Japan 25 years after the bust, neither household net worth nor stock prices have returned to their peak levels. By contrast, the U.S. stock market and household net worth have risen substantially above their 2007 peak levels.
Even the Fed now acknowledges that asset prices were then unsupported by economic fundamentals and contributed to the subsequent financial crisis.
How can the risk-reward of the Fed’s continued expansionary policies not account for the current high levels of debt and asset prices? The benefits of further supporting asset prices have fallen, and the potential costs of higher leverage continue to grow.
Near-zero rates during and in the years after 2008 no doubt helped end the so-called Great Recession.
But the U.S. economy is no longer under emergency conditions or facing the perils of 1937.
Why then does it require emergency monetary policy? While inflation targeting gave no warning of what was to come in 2008, why is inflation moving from 1.5% to 2% a necessary condition for raising rates from the current emergency levels? Even models that the Fed used to justify quantitative easing (QE) in recent years are today pointing to rates well above 1%. Why now use new, untested theories to justify zero?
Policy makers purport to be looking for signs of financial excesses. At present, private companies are being valued at $10 billion with no revenues. Corporations are borrowing $600 billion a year to buy back stocks at record prices. Leveraged loans, “covenant-lite” loans with loose loan requirements, and the high-yield bond market are well above their 2007 record size.
Even if policy makers judge that these levels are not excessive, since when do we need to see the seeds of the next crisis for an extremely accommodative policy stance to be reduced? Because excesses are seen best only ex post, policy should be cautious ex ante.
The two real culprits of the Fed’s constant moving of the goal posts are the prevailing “Bernanke doctrine” and the growing sense of unlimited power of monetary policy. In a famous speech to the American Economic Association in January 2010, then Federal Reserve Chairman Ben Bernanke postulated that the Fed had no significant impact on the housing bubble or on the increase in financial leverage and that monetary policy was too blunt a tool to be used to smooth asset cycles. After emphasizing for years that low rates have the ability to boost asset prices, under what criteria can the Fed insist that it had no influence on the boom preceding the financial crisis?
In the last six years and despite growing financial regulation, global debt (public and private) has increased by $57 trillion, three times faster than the growth of world GDP. Low real interest rates are likely responsible, at least in part, for this growth. So even if the causality between rates and asset prices is hard to discern academically, it seems unwise to assume that the current policy stance has no expected, future costs. Even if we are not on the verge of another crisis, the public debate should take account of the potential consequences of current policies.
After the severe stress generated by the Great Recession, was the cost not sufficient to warrant the pre-emptive use of a blunt tool like monetary policy? Given the relationship between interest rates and asset prices, the deflationary scare post-2008 could well have been mitigated by less expansionary policies in the early 2000s.
QE has ushered in a new sense of power by central banks. Yet monetary policy has limitations. It is mostly well-suited to filling in temporary shortfalls in demand. Except for exceptional conditions, it borrows growth from the future.
The Fed seems all-too-convinced that this is a trade-off worth making. With unemployment at 10%, history was likely on their side. At a 5.5% unemployment rate, it fails the test of history and common sense. May the risk-reward of too early versus too late prevailing in policy circles be backward?
Mr. Broda is a managing director at Duquesne Capital Management. Mr. Druckenmiller was the founder of Duquesne Capital and is the CEO of the Duquesne Family Office.
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