In “Liftoff: A Comparison of Two Normalization Cycles “ Bullard suggests a “combination strategy”
Many Federal Open Market Committee (FOMC) participants have said that the policy rate (i.e., the target for the federal funds rate) should come off the zero lower bound in 2015, with the exact timing dependent on how key macroeconomic indicators evolve. Given that this initial increase would mark the start of a normalization cycle, now is a good time to review the previous two major normalization cycles to see what we can learn from them.
The first normalization cycle for comparison began in 1994. The policy rate since September 1992 had been at 3 percent, which at the time was considered exceptionally low relative to the federal funds rate during the 1970s and 1980s. U.S. macroeconomic data indicated a strong economy toward the end of 1993.
In what was largely a surprise to financial markets, the FOMC began a normalization cycle in February 1994 and continued raising rates throughout that year. The normalization cycle ended in February 1995, with a policy rate of 6 percent.
Financial markets generally viewed this adjustment to higher interest rates as disorderly. In fact, the bond market had one of its worst years in 1994. The 10-year Treasury yield, for instance, rose roughly 2 percentage points that year. Despite being disorderly, the 1994 normalization turned out to be a success for the U.S. economy. The policy rate was returned to a more normal level, and the economy boomed in the second half of the 1990s—one of the best periods for economic growth in the postwar era.
The second normalization cycle for comparison took place in 2004-06. The policy rate had been 1 percent since June 2003. Leading up to the June 2004 FOMC meeting, real GDP growth remained solid, gains in nonfarm payroll employment had increased in recent months and inflation had risen. The FOMC raised the policy rate to 1.25 percent in June 2004 and continued with a mechanical pace of increase of 25 basis points at each of the next 16 meetings. Thus, there was almost no state contingency with this normalization cycle. In terms of communication, the FOMC was more transparent regarding its expectations for future increases in the policy rate than it had been previously. This cycle ended in June 2006, bringing the policy rate to 5.25 percent.
Financial markets viewed this form of normalization as much more orderly than the 1994 case and, therefore, a success. However, this normalization cyclemay have been counterproductive. The housing bubble inflated even more during this two-year period as financial markets found ways to create investments in housing based on cheap financing—investments that ultimately proved disastrous. Although policymakers were cognizant that house prices were rising and that mortgage finance was increasing, the general view was that the air could be let out of the bubble slowly and without dramatic macroeconomic consequences. In actuality, the opposite occurred. The housing bubble burst, starting in 2006, right about the time the normalization cycle ended. House prices fell about 30 percent, and the U.S. experienced a severe recession.
So, he suggests. “combine” them:
For the upcoming normalization cycle, some combination of the two—the data dependency from the 1994 case and the transparency from the 2004-06 case—would probably provide the optimal method of returning the policy rate to normal.
There´s so much that is misleading and wrong with Bullard´s story. The first but general (and conventional) point is the idea that monetary policy is synonymous with interest rate policy. Since the FF rate is “zero”, monetary policy is “adrift”. “Normalization”, therefore, requires a “liftoff” in rates.
The first chart illustrates the FF target rate highlighting the two “normalization” periods.
The second chart shows the 10-yr inflation expectations and the 10-yr Treasury Bond. What Bullard calls “disorderly normalization” in 1994-05 regards the fact that the 10yr TB jumped. But look at what was happening with 10-year inflation expectations. What´s the story behind that “quirk”?
Inflation had been trending dawn since the “Volcker Adjustment” in the early 1980s. Inflation took a significant drop following the 1990-91 recession (at the time that was referred to as “strategic disinflation”). So, when the Fed began to “normalize” policy agents maybe came to believe that the Fed was seeing a risk of inflation going up. Expectations adjusted, and the 10-yr TB went up to reflect that.
The “feeling” was temporary because soon inflation continued to fall. The chart illustrates.
Note that the second “normalization” takes place in a very different environment. Initially, rates had been lowered following the Russia crisis of mid-98. Then, in 1999-00 the FF rate had been increased owing mostly to the rise in oil prices (that took place after the Asian Crisis was “tamed” – See the disconnect between Headline & Core PCE inflation). That was viewed, subsequently, as a mistake by the Greenspan Fed so, on the first working day of 2001 the Fed, through a Conference-Call, began to reduce the FF rate, which was brought down to 1% in June 2003.
Although the recession was very shallow, real output growth and employment growth remained subdued. Despite rising oil prices (again), which impacted the headline measure of inflation, core inflation was low and even falling somewhat. [Note: this period (2002-03) combines a negative supply shock from the rise in oil prices and a positive supply shock from the tail-end of the rise in productivity growth which had begun in 1997. One increases inflation and reduces output growth. The other does the opposite]
That was the rationale for the Fed to announce, at the August 2003 FOMC meeting, Forward Guidance, where interest rates would remain at 1% for an extended period. “Normalization” of policy began almost one year later, when employment, real growth and inflation had picked up!
Bullard´s argument that the second “normalization cycle may have been counterproductive” is pure BS!
Although Bullard suggests “combining different aspects of the previous two “normalization” to guide the one forthcoming, the fact is that the 1994-95 and 2004-06 “normalization” cycles don´t have anything to say about the “desired normalization” in 2015 (2016? 2017?).
As we´ll see, while the Greenspan Fed did not let the “NGDP ball drop”, the Bernanke Fed managed to “throw it overboard”. That makes a “world of difference”!
The first chart covers 1993-97. Note how NGDP “hugs the trend level”. By late 1993, NGDP had closed in on trend. “Normalization” of policy meant not that policy was going to be tightened (rates increased), but that policy would strive to keep NGDP close to trend.
The second chart covers 1998 – 06. As mentioned earlier, this period was “tricky”. Too many things happened at the same time, and frequently with opposite effects on the variables of interest. First NGDP climbs above trend and subsequently falls below. Forward Guidance (FG) was decisive in “setting things straight”. After FG NGDP climbs back to trend, at which time policy is “normalized”.
What we have at present is something very different. Beginning in early 2008, NGDP is allowed to drop below trend. At the same time that a negative real shock (from the financial crisis) was going on, the Fed was extremely worried about inflation, indicating nominal spending (NGDP) would be constrained. And so it was “Bye-bye Blackbird” and the financial crisis only got worse, as did the economy.
Repeating a chart from before, note that after mid-2010 the correlation between 10-yr inflation expectations and 10-yr TB behaves very differently.
One plausible story is as follows. Once the recovery began in mid-2009, NGDP growth accelerated. After mid-2010 it “tapered off”. So there would be no “catch-up” growth. The NGDP growth chart illustrates.
With inflation expectations below target and expectations of low nominal and real growth going forward, there´s no reason for yields to rise! And so they fall. Notice that the start of the taper early last year clinches the “low growth-low inflation” scenario.
But the Fed is sure it´s almost time to “normalize”, whatever that means.