Yellen, like notorious previous Fed chiefs including Strong, Martin, and Greenspan, can now claim success in having prolonged and strengthened an asset price inflation which otherwise may well have been about to enter its severe end phase. If history is any guide, the result of that success is to be feared.
Asset price inflations — always characterized by monetary disequilibrium empowering irrational forces — go through a mid-late phase where speculative temperatures fall sharply in some markets which were previously hot. Overinvestment, falling profits, and a discrediting of once popular speculative hypotheses are the usual trigger to such quakes. The central bank can respond by fresh monetary injection and this sometimes brings a new round of speculative enthusiasm even possibly in the recently bust sectors. Symptoms of a sudden climb of goods inflation may emerge. The eventual denouement of crash and recession and the cumulative economic damage are very likely worse than if there had been no late-cycle inflationary stimulus.
The Fed Abandons Plans to Raise Rates
The present Fed resolved to apply the course of monetary injection in early 2016, backtracking from its program of once a quarter 25bp rate hikes heralded in late 2015. The catalyst was a New Year mini-crash in US equities alongside a China currency shock all in the context of a bust in the oil sector and a US growth cycle downturn (2015 and early 2016). In response to the weakening of the dollar the ECB and BoJ intensified their monetary experimentation whilst Beijing pumped up its state credit bubble. In December 2016, amidst evidence of a strong global and US growth cycle upturn, Yellen announced a resumption of tame sporadic “data-dependent 25bp rate rises with no balance sheet reduction.” Such a cautious rate trajectory could be consistent with further aggravation of monetary disequilibrium — in effect a strengthening of late-cycle monetary injections.
Lessons from the 1920s and 1930s
It was Alan Greenspan who gave his name to the long-practiced Fed treatment for late phase asset price inflation — the Greenspan Put. Benjamin Strong, however, was the pioneer back in 1927. Quakes were sounding in the great asset price inflation originating from the Fed’s price stabilization policies (low interest rates to counter downward influence on prices from rapid productivity growth) — the bursting of the Florida land bubble and then the crash of the Berlin equity market. The huge carry trade into the world’s then number-two economy, the Weimar Republic — in a massive highly leveraged speculative bubble amidst tales of economic miracle following the Reichsmark’s joining of the dollar standard in 1924 — threatened to go into reverse. (As a modern parallel think of China’s role in the present asset price inflation.) The US economy was in a mild recession and the US stock market had been on a plateau through 1926.
The then New York Fed governor Benjamin Strong responded in early 1927 by authorizing high powered money injections. Subsequently in summer he granted Morgan chum Montagu Norman at the Bank of England his request to help the struggling pound by cutting the discount rate (ignoring the protest of Reichsbank president Schacht who, as Murray Rothbard highlighted in his history of these events, feared a resurgent onslaught of speculative funds into Germany). In the new world of a global dollar standard where the recently created Fed had vast discretionary power in managing the monetary base, rate signals could be highly effective in a way not possible under the classical gold standard. The result was the tremendous speculative build-up in Wall Street accompanied by a re-bound of the carry trade into German bonds. The latter though began to wane as Germany entered recession already in the second half of 1928.
Late injections do not always work. The next asset price inflation starting in 1934 powered by the vast monetary base expansion at zero money rates under the Roosevelt Fed proves that lesson. Fed Chair Eccles abandoned in early Spring 1937 his planned tightening under pressure from the Roosevelt administration to “stabilize the bond market” (long-term yields had briefly jumped to 2.75% or higher from 2.25% at the start of the year) and counter an incipient stock market swoon. Though there was some modest market rebound through the spring, a crash followed in the late summer and the US economy entered simultaneously severe recession.
Maybe the Fed could have achieved more with bigger injections, though bleak geopolitical and domestic economic developments may have stymied these. In any case, counterfactual historians could argue that the failure of the “Eccles put” prevented a bigger bust further down the line. The Roosevelt Recession, though sharp, was over in barely a year.
The Greenspan Years
A similar point could be made with respect to 2007. Bernanke responded very tamely to the initial credit market quakes of summer 2007, sterilizing the Fed’s loans to the banks in distress out of concern that inflation was above target. A powerful monetary stimulus marked by aggressive monetary base expansion and rate cuts might have extended the cyclical expansion and buoyed asset prices into 2008 and 2009 but have culminated in an even bigger bust and recession than what occurred.
Greenspan was more masterful or lucky (hard to determine) in his administering of monetary injections late in the asset price inflation disease. His monetary injection of winter 1987 and spring 1988 in response to the October 1987 stock market crash (the asset price inflation had started with the Volcker Fed’s monetary stimulus of 1985–6 designed to devalue the dollar in accordance with the Reagan administration’s participation in the Plaza Accord) was highly effective. Asset prices re-bounded globally — with bubble temperatures recorded in Japan, Scandinavia, and US commercial real estate, before an upturn of goods inflation forced a reversal of monetary policy culminating in the crash and recession of 1990–2.
Similarly, late in the asset price inflation of the 1990s, as the emerging market carry trades crashed (first the disintegration of the Asian dollar bloc, then Russia’s bankruptcy) and Wall Street shuddered, Greenspan exercised his famous put of Autumn 1998, refusing to withdraw the money injected even as speculative temperatures soared in 1999 (including the Nasdaq bubble) out of concern that the Y2000 bug could smite the global economy at the start of the new millennium. A belated response by the Greenspan Fed to the inflation run-up in early 2000 (both assets and goods) catapulted the US economy into a hard landing.
Could Yellen Succeed Where Greenspan, Strong, and Martin Failed?
The Martin failure featured a late cycle strong acceleration of goods inflation. The Martin Fed exercised its put early in 1967 responding to a tumble in the stock market and to an economic slowdown wrought by its credit squeeze of the previous year. The put was successful in triggering a rebound of the stock market albeit that it only modestly surpassed the dizzy heights in real terms reached in late 1965. The accompanying shock rise in goods and services inflation forced a sharp monetary tightening which culminated in the crash and recession of 1969/70.
President Trump and his advisers may believe that Yellen can be the exception to the rule. The White House and the Republicans in Congress have taken no steps so far to pressure the Fed to abandon its late cycle monetary stimulus. Yes, Milton Friedman did famously comment that in a late stage of speculative fever it might be better to let markets burn out rather than suddenly tightening monetary policy. But that advice was in the context of the late cycle monetary injection having already ceased. That is a far cry from the present situation.