Tim Duy always has something thoughtful to say about the Fed. This comment in his latest Bloomberg column caught my eye:
But note too that Dudley looks disapprovingly on the 1994-1995 cycle. For policymakers at the Fed, that cycle has left an indelible mark on their psyche. They just can't shake it. And 2013's "taper tantrum," or the steepening of the yield curve in the wake of former Federal Reserve Chair Ben Bernanke's hints that quantitative easing was ending, revived their fear of a 1994 repeat. The Fed doesn't like a steep yield curve, but they won't like a flat one either.
I've seen a number of other people also refer to the Fed's fear of another 1994, when there was a bond market "bloodbath". This got me thinking about the Fed's delicate "psyche", which is so susceptible to indelible marks. What horrors occurred in 1994, as a result of the bond bloodbath? And where would I look for the evidence?
The obvious place to look is in the inflation and unemployment data, which are the two variables that the Fed is instructed to stabilize. Presumably something really, really bad happened to the economy in 1994, and left an indelible market on the Fed. So let's take a look at the inflation and unemployment data, before and after January 1994:
That's odd, I don't see much sign of a bloodbath. Inflation was running about 2% in early 1994, and continued at that pace until 1998. Indeed during the entire period from January 1991 to January 2016 inflation has averaged 1.88%, not too far from 2%. In fairness, that hides some instability, with inflation running at 2.14% for the first 17 years, and then only 1.33% in the 8 years after January 2008. It would have been better to have a bit less inflation during the first 17 years, and a significantly more since 2008. Still, the policy changes of 1994 don't seem to have created any major instability in inflation. So perhaps the bloodbath took place in the unemployment data?
Nope, unemployment was 6.6% in January 1994, and fell throughout the year, and indeed for another 6 years. And even then it rose only modestly during the 2001 recession, peaking at 6.3%. So the bloodbath doesn't seem to show up in the unemployment data.
I'd go even further, and argue that the macro data after January 1994 was some of the best ever seen in all of American history. And yet the Fed is so shaken by what happened in the mid-1990s that it dare not risk a repeat. In contrast, I want them to produce lots more periods like 1994-5.
Of course what's going on here is that the Fed's added a third mandate:
In the absence of a strong inflation argument to justify rate hikes, some Fed policymakers are leaning more heavily on a second narrative, the financial stability angle -- the fear that low rates foster asset bubbles or, perhaps worse, dangerously high levels of leverage within the financial sector.
However, it's not clear they know how to achieve it:
Raising interest rates alone may not alleviate financial stability concerns. In fact, they may aggravate those concerns if the yield curve continues to flatten. . . .
The Fed needs to think of policy in terms of using two tools -- rates and balance sheet -- simultaneously. Forward guidance alone might not be sufficient to allow the rate tool to mimic the impact of both jointly. In the current environment, should the Fed want to increase rates to tighten policy but at the same time be concerned about excessive flattening of the yield curve, they would need to sell long-dated Treasuries from their portfolio to normalize policy. Depending on conditions, this may be in concert with rate hikes at the short-end.
I wish the Fed would focus like a laser on macroeconomic stability (preferably NGDP, but inflation/unemployment are the current targets), and not use monetary policy to stabilize the financial system. But if they insist on doing something, I think Tim Duy's suggestion is a good one:
Bottom Line: The Fed needs to remember that how they got into this policy stance may offer a lesson for how to get out. Policy makers cut rates to zero and then instituted quantitative easing. Now they should consider selling assets before raising rates. Or, at a minimum, utilizing a mixed strategy of rate hikes and asset sales. The objective of meeting the Fed's mandate in the context of maintaining financial stability may be unattainable using the interest rate tool and associated forward guidance alone. Unfortunately, the Fed does not appear to be debating the policy mix -- at least not in public. They remain focused on interest rates, delaying balance sheet policy to a later date. On the current trajectory, however, that later date may never come.