The Fed Have Caused Every Post-War Recession

US Federal Reserve logo on note

There isn’t much going on in global markets right now. Stocks barely moved in overnight trade. The Dow fell a bit, the S&P rose a bit. Both remain near record highs, while seemingly everyone waits for the crash that never comes.

But the bears have a new ally. Central banks! Who would’ve thought?

As I mentioned yesterday, Ray Dalio, the head of the world’s biggest hedge fund, Bridgewater associates, says that it’s time to move one step closer to the exits. He thinks you should stay on the dance floor, of course, but now that central banks are slowly turning off the flow of easy money, he is wary.

The question is, as mentioned yesterday, at what point does the financial rate of interest rise above the natural rate and start impacting on stock prices and economic growth?

Because it absolutely will. The only question is when.

Have a look at the chart below. It shows the Federal Reserve funds rate from 1955. The shaded areas represent periods of recession. In every instance, rising interest rates have preceded recession.

That is, the fed tightened. The tightening led to recession, which then led the Fed to ease again, in the hope of reigniting the growth that they had just sought to stop.

Federal Reserve Fund rates 1955


Source: Federal Reserve of St Louis
[Click to enlarge]

Clearly the Fed has no idea where the natural rate of interest lies at any particular point in time.

That’s not a criticism. No one knows. I’m just pointing out that every rate raising cycle has led to recession, an obviously unintended outcome.

Based on the post-Second World War evidence, there is a good chance that this rate raising cycle will lead to a recession too.

How long will it take?

If you look at the gaps between recessions in the chart above, you’ll see that the US economy is currently experiencing one of its longest post-war expansions. It’s not the longest; the expansions of the 1960s and 1990s were longer. But not by much.

That means the current US economic expansion only has a few more years left before it enters unprecedented territory.

And squeezing out a few more years will depend on how fast or slow the Fed raises rates.

There is also the issue of ‘balance sheet normalisation’ to consider. That is, what effect will the Fed’s efforts to shrink its balance sheet (reverse quantitative easing) have on asset markets and the economy?

It’s safe to say that no know really knows. Still, we can take an educated guess.

To do that, you need to have a vague understanding of how quantitative easing works in the first place.

During times of ‘normal’ interest rate setting, the Fed (or any central bank) lowers rates by increasing the supply of reserves into the banking system. This increased supply pushes the price (the interest rate) down. The commercial banks then use this increased monetary base to create new loans, and this new credit flows through the economy.

When central banks pump enough money into the banking system, the interest rate effectively goes to zero. Despite there being ample money to lend out, the demand for credit just isn’t there. Conventional monetary policy loses its sting.

This is where quantitative easing (QE) comes in. Instead of the Fed increasing the monetary reserves of the banking system, it injects funds directly into the financial system by buying mortgage bonds and US government treasuries, creating cash to do so.

This had the initial effect of allowing banks to reduce their holdings of mortgage related debt (which allowed them to strengthen their balance sheets without dumping assets at fire sale prices and making the crisis worse).

Secondly, it had the effect of taking huge amounts of treasury bonds out of the market. This pushed market based interest rates down, and injected huge amounts of cash in the system.

This stabilised asset prices (by fulfilling the demand for cash without people having to sell assets at ever lower prices to obtain it) and also led to increased speculation.

The result was an end to the crisis and, years later, record highs in most of the world’s major equity markets.

So what happens now that the Fed plans to unwind QE? Is it as easy as just thinking that as the Fed shrinks its balance sheet, asset prices will decline? As comforting as that explanation might sound to the bears, or the logically minded, I think it’s just a little too neat.

The market never does what you expect it to. The market only makes sense in hindsight. Using foresight to work out what stock prices might do is much harder. In fact, it’s pretty much impossible.

Still, I’ll have a crack at it. But I’ll save the explanation for tomorrow. I want to explain how the psychological state of investors has a major part to play when it comes to trying to work out the impact of the Fed’s move to normalise interest rates.

You’ll also see why the Fed should employ just as many behavioural psychologists as they do economists in trying to work out how their policies impact markets.

But that’s never going to happen.

Anyway, stay tuned for tomorrow’s explanation (read guess) of how the world will respond to the Fed’s tightening.

Regards,
Greg

Editor’s note: Today Greg looked at the arc of the Fed’s recent interest rate policies, QE, and where they’ve led global markets. But what about a financial system outside central bank control, or any central control?

We’re not talking about gold. We’re talking about the cryptocurrency revolution. And, as well as an alternative to the manipulated and controlled world of central bank money, early investors could see incredible gains. Technology editor Sam Volkering has more, here.

Greg Canavan

Greg Canavan

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

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