I recently saw the transcript of this speech by William Dudley, President and CEO of the New York Fed. (HT: Tim Duy via EV). Here is an excerpt:
First, during the 2004-07 period, the FOMC tightened monetary policy nearly continuously, raising the federal funds rate from 1 percent to 5.25 percent in 17 steps. However, during this period, 10-year Treasury note yields did not rise much, credit spreads generally narrowed and U.S. equity price indices moved higher. Moreover, the availability of mortgage credit eased, rather than tightened. As a result, financial market conditions did not tighten. As a result, financial conditions remained quite loose, despite the large increase in the federal funds rate. With the benefit of hindsight, it seems that either monetary policy should have been tightened more aggressively or macroprudential measures should have been implemented in order to tighten credit conditions in the overheated housing sector.
Second, during the financial crisis, especially during the fall of 2008, financial market conditions tightened dramatically even as the FOMC was cutting its federal funds rate target to zero. Monetary accommodation turned out to be insufficient to produce an easing of financial market conditions, and the economy fell into a deep recession.
The third implication that stems from the fact that financial market conditions matter in the conduct of monetary policy pertains to the so-called “Fed put” with respect to equity prices. The notion here is that because the Federal Reserve cares about unanticipated and undesired changes in financial market conditions, the Fed will respond to weakness in equity prices by easing monetary policy—essentially providing a put to equity investors. The expectation of such a put is dangerous because if investors believe it exists they will view the equity market as less risky. This will cause investors to push equity market values higher, increasing the likelihood of an equity market bubble and, when such a bubble bursts, the potential for a sharp shock that could threaten financial stability and the economy.
So, these are the lessons the President of the New York Fed and Vice Chairman of the FOMC has learned from the crisis:
- Monetary policy was too loose in 2004-2007
- A signal that it was too loose is that long term interest rates were very low.
- Another signal that it was too loose is that equity price indices moved higher.
- Financial market conditions tightened dramatically in 2008, in spite of (I guess) the loose posture of Fed policy in 2007.
- The collapse in 2008 happened because monetary accommodation was impotent.
- The Fed should view low equity risk premiums as dangerous.
Here are some Year-over-Year changes in the S&P 500 Index
Here are some valuation metrics:
Avg. PE Ratio 11.8 - 7.9 22.7 - 17.4
Equity Risk Premium 4.6% - 6.5% 3.7% - 4.4%
Avg. Inflation Rate 5.5% - 8.3% 2.8% - 2.7%
Higher risk premiums mean lower stock prices, relative to fixed income investments. Aswath Damodaran at NYU tracks a measure of the Equity Risk Premium. It has averaged 4% since 1960. In 2004-2007, it was 3.7%, 4.1%, 4.2%, and 4.4%. (Higher premiums mean that investors are more risk averse.) Mr. Dudley's memory is quite fuzzy.
Monetary policy wasn't loose in the 2000s. It was in the 1970s. The supposed evidence that it was loose in the 2000s is that home prices and equity PE ratios were high. Here is one big reason why PE ratios are high today compared to the 1970s, even though equity risk premiums are as high now as they were then. It's because corporations in the US have massively de-leveraged over the past 40 years.
Here's a scatterplot of inflation and the S&P 500 Price/Equity ratio from 1948 to 2007. In 60 years of post-WW II monetary history, there literally is not a single instance where excessively high inflation triggered high equity valuation multiples. High PE Ratios are a signal of optimal monetary policy. I'd expect this sort of error from some gold-bug newsletter. But, how can the Fed think this way? Our explicit monetary policy regime right now is to miss the dual mandate. Equity risk premiums are currently at the top end of their long-term range, over 5%, and Mr. Dudley is poised to hit us sooner and harder if the Fed can manage to bumble into the range of optimal policy long enough for risk premiums to get back down to the long term average.
Just a reminder: The pressing concern of the Fed even after the Lehman failure in September 2008 was inflation. They held the Fed Funds rate at 2% in September as a stand against phantom inflation, and then, even after that, began paying interest on excess bank reserves. The idea that they were pushing desperately for accommodation is quite revisionist. This revisionism is especially surprising, since Mr. Dudley was the Manager of the System Open Market Account for the FOMC at the time, and said this to the committee at that September meeting:
So I think the consensus view still in the marketplace is that the Fed probably will not cut rates today. That would be a disappointment to a degree because there’s some probability placed on the idea that the Fed might do 50, but that’s how I would interpret what’s priced into the markets today........But I think it’s hard to interpret because it’s really not about 25 versus zero. It’s really about zero versus 50 or maybe even 100 as you look out longer term. Either the financial system is going to implode in a major way, which will lead to a significant further easing, or it is not.And the response from the FOMC at that meeting was to hold interest rates at 2%. And now Mr. Dudley says, "Monetary accommodation turned out to be insufficient to produce an easing of financial market conditions, and the economy fell into a deep recession."
The day of the meeting, the Reserve Primary Fund broke the buck. The next day, the Fed bailed out AIG, the day after that Bernanke told Congress that without TARP we "may not have an economy on Monday", a week later WAMU fell, and two weeks later, the Fed finally lowered the Fed Funds Rate by 50 basis points, but also implemented interest on reserves. At the October 8 meeting, the revisionism had already begun. Tim Geitner comforted the committee, "The argument that makes me most uncomfortable here around the table today is the suggestion several of you have made... which is that the actions by this Committee contributed to the erosion of confidence—a deeply unfair suggestion." And, now that very same Mr. Dudley tells us that there was just nothing the Fed could do.
Statements like this coming out of the FOMC make me very pessimistic about the near-term downside scenario. If the mortgage market loosens up, long term interest rates should move higher. In that case, the decline in shelter inflation and the Fed's down-is-up point of view might actually give us a couple of years before the clamps come down. But, if mortgages don't recover, interest rates will remain low. And, the Fed apparently will interpret this as a sign of loose money (!). Now, I think that the economy might be ok with a percent or two of rate hikes, which makes me somewhat sanguine about the immediate damage. But if real interest rates remain low because of the lack of demand coming through mortgages, and equity premiums manage to drop a little bit in that context, equity PE ratios could get pretty high if the non-housing economy can manage to grow in the face of rising short term rates, and the only way to bring them down will be to destroy some portion of the capital base through monetary mismanagement. And, apparently, annual returns in equity markets of 3%, 8%, and 13% are signs of a speculative fever to the FOMC.
(Follow up post)