Partying like it’s 1994
This post is a riff on a Paul Krugman post he titled “Partying Like It’s 1995”. I cam across Krugman’s post via Stephen WIlliamson, who makes some valid points about the Fed’s raising rates in 1994 that bear noting.
Now, Krugman talks about the mid-1990s nostalgically, pointing to 1995 with fond memories and exhorting the Fed to use the same policies in dealing with the economy today.
The thing is, we’ve been here before. In the early-to-mid 1990s, the Fed generally estimated the Nairu as being between 5.5 percent and 6 percent, and by 1995, unemployment had already fallen to that level. But inflation wasn’t actually rising. So Fed officials made what turned out to be a very good choice: They held their fire, waiting for clear signs of inflationary pressure. And it turned out that the United States’ economy was capable of generating millions more jobs, without inflation, than it would have if the Fed had reined in the boom too soon.
I disagree with the tenor of these comments because anyone who was in the markets in 1994 cannot see it the way Krugman does. The way I remember 1994 is as a bloodbath in which fixed income departments melted down and my friends were getting laid off left and right. It was a horror show. And that’s why, on Friday, I wrote that my concern about 2015 as 1994 using a chart from Tim Duy’s Fed Watch.
And so it was good to see Williamson get the history right about Fed policy in 1995.
“by early 1995, the Fed had just finished a substantial tightening cycle – the fed funds rate had increased from about 3% at the beginning of 1994 to about 6% at the beginning of 1995. So, the Fed wasn’t “holding its fire” in 1995, it had just launched a major artillery barrage, and had stopped shooting until the smoke cleared. And the fed funds rate in 1995 was at 6%, not at (effectively) zero, as is the case now.”
I am actually surprised Krugman talks up 1995 this way because everyone I know who was close to the bond markets in the mid-1990s remembers 1994 as a particularly gruesome episode in which the Fed hiked rates aggressively and unexpectedly, leading to massive losses at some firms. I just Googled “fixed income 1994 goldman” and came across two articles, one a contemporaneous piece from the NY Times about Jon Corzine becoming head of Goldman Sachs despite the volatility in fixed income that year and the other from Vanity Fair in 2011 by William Cohan, looking back on 1994 as the year Goldman became a firm dominated by traders (similar I would say to Salomon Brothers and a major reason I called it “The Age of the Trader” in 2010).
Would the 2015 Fed raise rates so aggressively and unexpectedly? Would we want that? I would say no to the first question and leave the second question for you to answer. The way I characterized today’s Fed’s approach on Friday was to say that “the path from quantitative easing to rate hikes is a. taper QE; b. end QE; c. stop and re-assess d. end ‘’patience’ and move to a full-on tightening bias e. and then re-assess again”. We are now in the second re-assessment period before rate hikes, making now akin to 1994 and not 1995.
The interesting bit is Williamson’s part on the Taylor Rule, which David Beckworth perhaps might disagree with because David told my finance show host Erin Ade that the 1998 version of the Taylor Rule puts the Fed’s interest rate policy about dead-on at the zero lower bound after being deeply negative these past few years. Williamson noted this at the end of his post:
Note that policy is actually tighter in 1995 than average Fed behavior over the 1990s predicts. But what if the Fed followed Krugman’s advice and behaved like it did in the 1990s? Well, the fitted Taylor rule, given an unemployment rate of 5.5% and a pce inflation rate of 0.2%, implies a fed funds rate of 2.8%. So if the Fed had been behaving like it did in the 1990s, it would have lifted off the zero lower bound long ago. Apparently Krugman is confused.
And, if you follow what Yellen said and did from that period I would say she is more hawkish than the markets believe her to be (see tweets here, here, here, here and here). As I see it, we are on the path to a rate hike by the end of September.