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Economy in Brief

Is The Fed At Risk of Repeating the Mistakes of the Past?
by Joseph G. Carson ([email protected])  June 11, 2019

Before policymakers decide to provide an insurance cut, or two, against potential destabilizing events in the financial markets, or react to any economic weakness that may be linked to trade disputes it would be prudent on their part to review past experiences. Nowadays the cost-benefit analysis can no longer be limited to the growth and inflation trade-offs but need to also include inferences about how asset markets may respond to policy easing.

In hindsight, hard evidence from past insurance cuts is that they were unnecessary, too large or left in place far too long, triggering sharp gains in already too-hot asset markets, creating economic and financial imbalances in the process, and resulting in the very bad outcomes policymakers were seeking to avoid. Do policymakers want to risk repeating the same mistakes? And do they have any choice?

Looking back, the monetary policy decisions made during the Russian debt default in the summer of 1998 could be considered a watershed moment in the annals of Federal Reserve. To be sure, the decision to act preemptively and decisively without any hard evidence that the economy would be affected by the turmoil proved how sensitive policymakers were to any potential disruption in the domestic financial markets, an action that has been repeated time and again.

At the time of the Russian debt default, the US economy was expanding at a relatively rapid pace. Yet, to be fair, policymakers were unsure how the seizing up in the domestic financial markets would affect the economy. Federal Reserve Chairman Alan Greenspan stated “it is not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress.” Given his concern, Mr. Greenspan engineered three 25 basis point cuts in official rates cuts, one at an emergency meeting, over a short three-month span.

Yet, not only did the US economy show no ill-effects from the financial turmoil, evident by it expanding over 5% and 6% annualized in the third and fourth quarters of 1998, it also become a hot-bed for asset market speculation.

The NASDAQ composite index, which was home to many of the fast rising new start-up tech companies, had already doubled in the previous three years leading up the Russian default, and doubled again in the 14-month period from when policymakers initially eased in September 1998 until they fully reversed the three official rate cuts by November 1999. The NASDAQ eventually climbed another 50% in the early months of 2000, before crashing in late 2000 and beyond, triggering an economic correction and financial instability in the process.

In hindsight, it is difficult to prove one way or the other how the economy would have performed without the easing of monetary policy. Yet it is hard to deny that monetary ease occurring at a time of speculative asset markets did not channel more flows into in the hot equity markets. .

Another period of monetary accommodation staying in place far too long occurred during the period immediately following the bubble burst. In order to cushion the economy from the bursting of the tech-equity bubble policymakers lowered the federal funds by 550 basis points to 1%, the lowest level in 45 years, in a span of two-and-half years and left rates at 1% for an additional year.

The decision to keep official rates at very low levels was a risky proposition because there was accumulating evidence that record low interest rates was triggering another asset price cycle, yet this time it was in residential real estate. During the 2001-04 period house prices climbed nearly 40%, the largest gains in nearly 30 years, and yet policymakers continued to downplay the rise or even link the move to its official rate policy stance. Even after policymakers started in mid-2004 to lift official rates up in a “measured way” residential prices climbed another 40% over the next three years, before crashing in a dramatic way in 2008 and beyond, not too unlike the bust.

In the past policymakers had limited information on the full range of possible outcomes associated with an easing or insurance move, but inferences about how the economy and market participants might respond to policy easing can now be drawn from the hard evidence of past behavior during periods comparable to the current environment. Fast rising equity markets, often used as a gauge of the stance of overall monetary policy indicates that policymaker’s run the risk of repeating the mistakes of the past by engineering an easing of policy at this time. Yet, given the political environment and statements by a few policymakers do they have the option not to act?

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