I wrote in E-MorningCoffee in May 2021 about the last period of severe inflation in the U.S., which occurred in the 1970s / early 1980s: “Inflation: Transient or Persistent, Lessons from 1970s”. Understanding the last period of high inflation and how it was addressed is certainly topical at the moment since the US is now experiencing its highest level of inflation in 40 years.
When I wrote that article last year, I had a second period of time in mind that I also wanted to better understand – the decade of 2010-2020. This decade started at the end of the Great Recession and ended just before the pandemic. It was a period that involved proactive monetary policy by the Federal Reserve to nurse the economy back to health following the deepest downturn since the Great Depression. To right the economic ship during the decade, the Fed utilised a wider variety of policy tools than it had used in the late 1970s / early 1980s, introducing asset purchases into its repertoire.
Why are the actions by the Federal Reserve in the last decade relevant today, especially since inflation was never really an issue during that entire 10-year period (but is today)? The Fed is about to embark on a path of monetary tightening, including both rate rises and quantitative tightening. The Federal Reserve is reacting late since it incorrectly thought that the inflation that emerged from gobs of monetary and fiscal stimulus – freely flowing during the pandemic – would be short-lived, or transitory. Now, the Fed has little room to navigate because inflation is continuing to increase month after month, raising the risk that it could become entrenched. Inflation is also being heavily influenced by supply-push factors like supply-chain disruptions and higher energy costs, both exacerbated by the unforeseen and unfortunate war in Ukraine and ongoing COVID-shutdowns in China, the world’s second largest economy. These are stark reminders that the Fed cannot control all of the inflation levers. Addressing inflation is inevitably going to be a tricky exercise for the Federal Reserve, with the probability of a soft landing far from assured. With the Fed putting the brakes on the US economy, there is risk that the economy gets tipped into a recession or that a prolonged period of high inflation and low growth (i.e. stagflation) occurs. To make matters more complicated, the US stock and bond markets are losing ground, too.
Let’s start this discussion by first looking at the performance of the US economy during the last decade and compare it to where we stand at the moment.
Performance during the decade
During the period 2010-2019 (Dec 31st 2009 to Dec 31st 2019), the US economy experienced:
average real GDP growth of 2.2%/annum (albeit there were three (non-consecutive) quarters during the decade when real GDP declined – 1Q2011, 3Q2011 and 1Q2014;
average CPI of 1.8%/annum; and
average unemployment rate of 6.2%/annum (skewed by high unemployment in the first several years of the period).
Financial markets, especially risk markets like US stocks and real estate, performed very well during this decade, largely assisted by accommodative monetary policy courtesy of the Federal Reserve. During the decade:
The S&P 500 index nearly tripled from 1,115.1 at the end of 2009 to 3,230.78 at the end of 2019, a CAGR of 12.6%/annum (excluding dividends) over this 10-year period;
The average yield on the 10-year US Treasury was 2.41%; and
The Case-Schiller U.S. National Home Price index returned on average 4.3%/annum over the period, even though it took the first half of the decade for the US real estate market to recover from the mortgage debacle that led to the Great Recession.
The table below compares the economic and financial markets metrics during the decade of 2010-2020 to those we are experiencing now.
As you can see in the table, the US economy is currently at full employment (3.6% U/E rate) and is experiencing severe inflation (CPI 8.5% YoY in March). The Federal Reserve is acting late and feels increasingly boxed in. In anticipation of this monetary policy shift, the US equity markets are selling off as the Fed embarks on a hawkish path, whilst UST yields are sharply higher, especially at the short end of the curve. US real estate has also appreciated sharply since the pandemic started, and the risk of a bubble bursting in this asset class is not often discussed yet but could be very real.
The actions of the Federal Reserve
Having studied the monetary policy actions of the Federal Reserve during the decade of 2010-2020, I identified three critical inflection points that are worth discussing which are relevant to the Fed’s stance as of the moment.
Tapering (2013/14): The winddown – or tapering – of the third (and final) phase of Great Recession-induced quantitative easing, which was announced by then-Fed Chairman Bernanke in May 2013, began formally in December of 2013 and ended in October 2014. Today, the Federal Reserve has ended its asset purchases, and is in fact preparing to go one step further as it begins to reduce its balance sheet.
The Fed pre-empts potential inflation (2015/18): The Fed pre-empted potential inflationary pressures following the end of QE in 2014 via a series of increases in the Federal Funds rate, starting from nil in December 2015 and raising the rate nine times until December 2018 (to 2.25%-2.50%). The Fed is starting to raise the Federal Funds rate now. It is now clear that the Federal Reserve started its tightening stance too late as inflation remains severely elevated.
The Fed capitulates (2018/19): The Fed paused its rate rises in December 2018 following a decline of almost 20% in the S&P 500 in 4Q2018, and then shifted back to an accommodative monetary policy stance starting in July 2019 even though the S&P 500 had recovered fully from the 4Q19 decline and the unemployment rate was near full-employment. Growth was also steady, coming in at 2.3%/annum for 2018 (real GDP, 4Q17 to 4Q18), and inflation was never an issue. Currently, the S&P 500 is down 16.3% YtD, we are at (or very near) full employment, and US economic growth is slowing but down from pandemic highs. A major difference now versus the 2018-2019 loosening period is that the US economy is currently experiencing the highest inflation in 40 years.
The lead-in to the 2010-2020 period: The Great Recession (2008-2009)
You might recall that the Federal Reserve started lowering the Federal Funds rate in 2007 as it was becoming increasingly apparent that a US mortgage crisis was unfolding. The Fed decreased the Federal Funds rate 10 times between September 2007 (from 5.25%) and December 2008 (to nil, the lower bound). The looming and rapidly spreading real estate mortgage crisis gradually undermined the integrity of the entire US financial system, causing substantial systemic risk to develop in the US banking system. Bear Sterns was sold at a distressed level to JPM in March 2008, GSEs Freddie Mac and Fannie Mae were effectively nationalised, and Lehman Brothers was allowed to fail in September 2008. Confidence in the US banking system was dangerously low. Banks, not knowing the size and composition of troubled mortgages on one another’s balance sheets, effectively stopped lending to each other, locking up the interbank funding market so essential for banks to fund their day-to-day operations. To combat this situation, which was quickly spiralling downhill and increasingly out of control, the Federal Reserve and Treasury Department undertook a series of steps to restore confidence in the US banking system. The Federal Reserve turned to an unconventional form of monetary stimulus in the form of quantitative easing (“QE”), which was used alongside decreases in the Federal Funds rate. The unconventional and highly accommodative monetary policies unleashed by the Federal Reserve during the Great Recession were done in conjunction with
Fiscal stimulus: $800 billion fiscal stimulus package passed by Congress in February 2009 (the “American Recovery and Reinvestment Act”), and
Bank reform: The “Emergency Economic Stabilization Act of 2008” signed into law in October 2008 by then-President Bush. This Act consisted of bank (and later automotive finance) rescue financing packages and purchase facilities for toxic assets (i.e. mortgages) in the form of the $700 billion “Troubled Asset Relief Plan”, or TARP. The programme also included a $250 billion Capital Purchase Program to provide equity capital to US banks and insurance companies, including the likes of Citibank, Bank of America and AIG.
These collective measures from the US government and Federal Reserve helped stabilise a fragile banking system and right an economy that was suffering from its worst downturn since the Great Depression.
This is the context so let’s now look at the three periods of monetary policy that I believe were most interesting during the Great Recession and the decade that followed.
The period of Quantitative Easing (2008-2014)
As the economic outlook was becoming increasingly cloudy by mid-2007, the Federal Reserve began to lower the Federal Funds rate from 5.25% in August 2007 to effectively 0% by December 2008. As the overnight bank borrowing rate neared its lower bound (of zero), the Federal Reserve was forced to turn to unconventional monetary policy in the form of asset purchases – known as quantitative easing – to bring down longer term interest rates and to provide some support for the mortgage-backed securities market, which had locked-up. Ultimately, the Great Recession started as a real estate crisis that quickly turned into a much broader financial crisis. QE involves the purchases of assets by a central bank in the secondary market. QE is used by a central bank only in extraordinary circumstances and generally only after the overnight bank funding rate (the “Federal Funds rate”) has reached its lower bound. Because QE is considered inflationary and dramatically increases the size of the balance sheet of a central bank, it is rarely used except during very severe circumstances.
In November 2008, the Federal Reserve started what turned out to be three phases of quantitative easing over a six year period. Yardeni Research has a very concise summary of the key moments and milestones during the 2008-2014 period (see here), which you might wish to reference. The article also includes links to the relevant Federal Reserve policy statements that were released at every important step along the way.
The three phases of QE over six years increased the Federal Reserve’s balance sheet from $900 billion to nearly $4.5 trillion as a result of asset purchases. The table below illustrates the amount of aggregate and type of asset purchases during all three phases of the QE programme during this period.
Initially, the Federal Reserve bought i) US Treasuries in order to keep longer-term interest rates low so as to stimulate consumer and business borrowing, ii) mortgage-backed securities to ensure that this market remained functional (basically meaning that the Federal Reserve became a buyer of toxic mortgages from banks which needed to maintain their funding lines), and iii) agency debt, namely debt of Fannie and Freddie so these agencies could also continue to fund themselves.
The graph below from FRED shows the migration of the US unemployment rate, CPI, the Federal Funds rate and GDP during the six years that included QE, from Jan 1, 2008 to Dec 31, 2014.
As you can see in this graph, unemployment steadily declined after reaching 10% in January 2009, growth finally returned to positive in 3Q2009, and inflation remained largely in check throughout the period. The Federal Reserve’s extreme policy measures, whilst unconventional, arguably saved the US economy from what could have been a much more severe and prolonged downturn. Moreover, the easy money policies did not lead to inflation, mainly because even at the end of this period, the US economy was far from full employment (unemployment rate in December 2014 was still 5.6%).
The financial markets also recovered rapidly as investors gained confidence that the recession would end at some point and economic growth would resume. The table below shows the performance of the S&P 500 and US residential real estate over the six-year period of QE, as well as the yield compression in US Treasuries (2y and 10y) and change in spreads in investment grade and in high yield corporate bond spreads.
Clearly the equity and bond markets were rapidly improving, and investors that bought in as panic gripped the market ended up doing very well during this period of recovery. However, the real estate market was so over-valued at the onset of the recession and the mortgage crisis was so severe that even the excesses in this market had not been fully worked out by the end of 2014. In fact, it wasn’t until September 2015 that the US residential real estate market finally returned to the level at which it started 2008.
“Taper Tantrum”
One critical event during this period was the market’s reaction to the wind-down of QE, or “tapering”. The bond market reacted very poorly to then-Fed Chairman Bernanke’s comments before Congress (and in a Fed press release here) in May 2013 that the Federal Reserve would start to reduce – or taper – its monthly asset purchases in the coming months. This led to the infamous “taper tantrum” during which the yield on the 10-year US Treasury – which had been steadily declining prior to this announcement – started to steadily increase, rising from 1.66% at the beginning of May 2013 (pre-tapering mention) to 3.04% by the end of 2013. Nonetheless, the Federal Reserve followed through on its announced intentions to reduce its monthly asset purchases starting in December 2013. Janet Yellen, who became the Fed Chair in February 2014, continued with the winddown of QE, eventually ending the unconventional approach altogether in October 2014. By the end of 2014, the bond market had settled down, and the yield on the 10-year US Treasury had decreased to 2.17%.
The Federal Reserve’s balance sheet, which was $900 billion or so prior to the Great Recession and implementation of its three-phased QE programme, had increased to $4.5 trillion by the end of 2014.
The Federal Reserve tightens monetary policy again (2015-2018)
Once QE ended, the US economy continued to chug along, as did financial markets. In December 2015, the Federal Reserve under Chair Janet Yellen began a series of increases in the Federal Funds rate as a pre-emptive measure to ensure that the US economy did not get overheated. At the time, there were no real signs of inflation (CPI less than 1%/annum) or severe asset bubbles. Unemployment had fallen to 5.0% by December 2015, still arguably some ways from full employment, and the US economy had been growing at a respectable clip (2.2%/annum 3Q15 vs 3Q14). The gradual increases in the Federal Funds rate continued when Chairman Jerome Powell took over the Federal Reserve in February 2018, increasingly to the chagrin of President Trump, who regularly lambasted Mr Powell for continuing to raise interest rates. Nonetheless, the Fed continued to raise the Federal Funds rate. During this three year period from December 2015 to December 2018, the Federal Funds rate was increased nine times, all in 25bps increments, from 0-0.25% to 2.25%-2.50%.
Quantitative Tightening
In June 2017, the Federal Reserve announced that it would start to decrease its balance sheet by not completely replacing bonds as they matured, a process known as quantitative tightening (“QT”). The Federal Reserve started QT in the autumn 2017 (Fed press release here). By the end 2018, the Fed had reduced its balance sheet to $4.076 trillion, a decrease in assets of over $400 billion.
For much of this three year period that included steadily tighter monetary policy, the US economy continued on a moderate growth track and unemployment continued to slowly decline. However, when QT started, the bond market reacted as might have been expected. The yield on the 10-year US Treasury increased from 2.05% on Sept 17th, 2017 to 3.24% on Nov 8th 2018, perhaps only abating in the fourth quarter of 2018 due to a flight-to-quality as US equities were by then under severe pressure. US economic growth began to deteriorate in 2018, although unemployment did not materially increase. 2Q2018 GDP was 3.3%/annum in 1Q2018 but slowed to 2.3%/annum by 4Q2018 (and went on to decline to 2.1% by 2Q2019).
It is important to point out that then-President Trump signed into law the Tax Cuts & Jobs Act (“TCJA”) in December 2017. This plan was meant to be fiscally neutral, although most economists think it increased the deficit (and was de facto a form of fiscal stimulus). What is clear is that the TCJA did not seem to have a material positive effect on the US economy in 2018, although keep in mind that the plan’s benefits were not a “one time shot” but rather were to inure over several years. It was monetary policy that remained front & centre.
As US economic growth slowed modestly during 2018, economic concerns started to negatively affect investor sentiment. Sentiment worsened as the year wore on, culminating in a decline in the S&P 500 of 14.7% in 4Q2018, a sharp drop in only a three month period. In fact, a rally in the last week of the year made a horrible quarter for equity investors slightly less bad – the S&P 500 was down 19.3% on Christmas Eve before staging a recovery in the final week of the year!
The Federal Reserve capitulates
Not only was then-President Trump blasting the Federal Reserve and personally demeaning Chairman Powell by this point, but equity investors had also clearly began a revolt. The Federal Reserve’s dual mandate is to maintain steady prices (underlying assumption is 2%/annum CPI) and maximum employment. Unemployment during 2018 had bounced between 3.8% and 4.0%, but there was no discernible trend by the end of the year as far an unemployment either increasing or decreasing. CPI (inflation) averaged 2.4% for the year and had been slowly decreasing throughout the year. By December 2018, CPI had fallen to 1.9%. US economic growth was slowing, but not dangerously so, unemployment was steady, and inflation was on target.
Even though the economy seemed fine by almost any measure, the Fed buckled under pressure in December 2018 and announced that it would end its three-year period of increases in the Federal Funds rate. Although the central bank stopped raising the Federal Funds rate at the end of 2018, it carried on with its QT programme well into 2019, eventually reducing its balance sheet to $3.76 trillion by August 2019.
In July 2019 – even as the stock market had recovered (+18.9% YtD to July 31), growth remained firm albeit at the 2.1%/annum level (real GDP growth in 1Q19 and 2Q19), and unemployment had fallen to 3.6% with no sign of inflation – the Federal Reserve capitulated further and announced that it would lower the Federal Funds rate on August 1, 2019 by 25bps (to 2.00%-2.25%, press release here). With QT also halted, this provided a further boost to US growth which then improved to 2.6% by 4Q2019.
Interestingly, when the Federal Reserve stopped QT in the summer 2019, it turned around and almost immediately had to start purchasing assets again because of unstable money markets and a surge in overnight bank borrowing rates related to repo agreements, which was leading to instability in the bank markets in September (2019). The Fed maintained that restarting asset purchases was not a QE phase 4 since the asset purchases were for a very different reason than those justifying QE used during the 2008-2014 period. This topic is a bit complicated for me, but the Federal Reserve provides a very good explanation on its website in an article published in February 2020 that you can find here. I am warning you – it is very technical! The bottom line is that the Federal Reserve started purchasing assets again, causing its balance sheet to increase to $4.17 trillion by the end of 2019, with the pandemic just around the quarter as the decade ended.
Conclusion
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In some respects, we are in familiar territory now, although we have gotten here in a much more aggressive fashion though a combination of monetary stimulus but also fiscal stimulus that was many times the amount unleashed during the Great Recession. Equity investors, similar to late 2018, are starting to panic over the effect of higher interest rates. The differences though are that inflation is substantially higher now and it is clear – in retrospect – that the Federal Reserve has acted late rather than pre-emptively as it did in late 2015. This tightening round has arguably been heavy on rhetoric and light on action, so the Federal Reserve is playing a catch-up game, no doubt greatly increasing the risk that they will overshoot and push the US economy into recession. This is a very material risk at the moment, and only time will tell if the Federal Reserve can dig itself out of a hole.
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