Tuesday, April 3, 2018

The stock and bond hedge in the Great Moderation

It looks like the cyclical relationship between interest rates and stock market trends was different before the Volker Fed than it has been after the Volker Fed.

The vertical marks  note times when short term interest rates began to decline.  Before 1980, this would usually happen after a stock market decline, and the stock market would recover when interest rates began to drop.  During that time, both bonds and stocks were gaining and losing value at the same time.

Since 1980, stocks have generally only started to lose value after interest rates began to decline.  During this period, bonds have gained value when stocks were losing value, so that they have served as hedging instruments.  I expect this to happen again.  There is a chance that in this cycle, stock prices won't give up much, like in the 1990-1992 period, in which case bonds will provide more of a speculative return if there is a general contraction, even though we are close to the zero bound.  A pure speculative position would probably require using something like Fed Funds Rate or Eurodollar futures, because short term notes don't have much price reaction to yields and long term bond yields don't change as much as short term yields.

It would be nice if high asset prices weren't an outcome that is explicitly avoided.  I am not saying high asset prices should be a goal, in and of themselves, by any means, but when the Fed pulled down short term interest rates in the mid-1980s and the mid-1990s, those moderating moves were probably an important part of the Great Moderation, where extended periods of 2%+ real economic growth per worker were only interrupted by minor recessions.

In both cases, the stock market reacted favorably, but both times (1987 and 2000) that was followed by a retreat, so stable economic growth has come to be associated with ill-advised risk-taking and "paper" wealth that leads to economic or market upheaval.

I would much rather live in the late 1990s than the 1970s.  Anyone would.  High inflation in the 1970s suggests that monetary policy actually was too loose then, and stocks hated it.  Workers did, too.  Unemployment was high.

In the 1990s, inflation was low, wages and employment were strong, and stocks like it.  The Greenspan put wasn't a form of monetary over-reach.  It was closer to monetary optimization.

We still have a relatively stable monetary regime, because inflation isn't going to get out of control, and the central bank will eventually provide monetary support during the contraction, but the fear of high asset prices now seems to have us in this de facto policy regime of keeping inflation low enough to target low wages and low asset prices.  I don't see the point of that, but it's where we are.  And, in the meantime, a flattening yield curve should indicate a coming broader contraction, which will signal declining short term interest rates.

I don't necessarily have a thorough explanation for the pre-Volker pattern.  In general it seems that inflation at the time was more pro-cyclical.  A primary feature of the Great Moderation period seems to be that inflation isn't as pro-cyclical.  It remains moderate during expansions.  That is a development for the better.  I wonder if we have become a little bit too afraid of success.  A couple more timely ticks down to avoid an inverted yield curve in 2000 and 2006, as happened in the mid-1990s, and maybe the Great Moderation could have been even Greater.

Maybe there is something about the way markets have evolved (more global corporate revenue bases?) that makes the stock market less of a forward indicator, and the fact that the stock market is bound to influence the monetary stance biases us to a slightly delayed monetary reaction.  Pre-Volker, the economy seemed to swing to sharp highs followed by brief crashes.  The 2007 recession was preceded by several quarters where economic growth slowly ground lower.  To a lesser extent, that was the case in 2000 and 1990.  Prior to that, recessionary shifts in growth tended to happen quickly.  It seems plausible that we have learned to do things pretty well.  We don't have numerous quick contractions anymore.  But there is something keeping us from loosening up when recessionary conditions slowly build.

Of course, the idea that moderation in the 2000s led to a housing bubble only serves to buttress this bias toward disinflationary instability.  I consider those slowing quarters in 2006 and 2007 to be early signs of cyclical miscalculations.  But, most people think the problem was that we didn't invoke that slow growth sooner.  The Moderation won't be Greater until that idea is reversed.


  1. Excellent blogging.
    I wonder why there has been an increasing squeamishness among central bankers to even rather low rates of inflation.
    I would prefer the sentiment that you suggest in this post, that when the economy slows the central bank should consider stimulus.

    Money-financed tax cuts to preempt a recession sure strikes me as a good idea.

    1. Couldn't you describe conventional MP as money financed tax cuts?

  2. Greenspan Put: that's the negative way of describing the 4 times the Fed listened! ;-)

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