From Eric Peters, CIO of One River Asset Management
The fed funds rate was 9.75% when I arrived in the pit, Chicago 1989. US GDP that year was 3.7%, unemployment 5.4%, and inflation 4.6%. But the S&L crisis was widening, as they do. So the Fed cut rates 75bps. Back then, the Fed certainly didn’t signal its intentions. In fact, the Fed neither confirmed nor denied what changes it made to interest rates even after it made them. Unimaginable, right? So we had to guess Fed policy changes by observing what happened in money markets. I obviously didn’t understand any of it, after all, I was an economics major.
The S&P 500 loved that 75bp rate cut more than it feared the S&L crisis, so stocks took out the 1987 peak, making new highs in the autumn of ’89. There was still tons of brain damage from ’87, and traders are notorious for being superstitious, so the pit was nervy that October. When the S&P plunged -6% out of the blue on October 13th, the trading pit went utterly berserk. I was so happy in that market mayhem. Soon enough, the Fed cut rates another 75bps. The S&P 500 grinded back up through the end of my first year, but never made new highs.
Despite the 150bps of rate cuts in 1989, and the record S&P highs, the economy soon entered a recession. The Fed kept cutting rates for a couple years, ending at an impossibly low rate of 3.00% in Feb 1992. US GDP was 3.5%, unemployment 7.4% and inflation was 2.9%. I had made my way to London that year as a prop trader, just in time for the Exchange Rate Mechanism collapse. The Europeans had created a system to ensure stability, certainty. And this naturally encouraged traders and investors to build massive leveraged investment positions.
When systems designed to ensure stability fail, which they inevitably do when applied to things as unstable as economies, the consequences are profound. As Europe worked through its ERM collapse, Greenspan held fed funds at 3.00% for what seemed an eternity. No one could understand anything he ever said, so you can’t blame him for promising certainty, stability. But people see what they want to see, hear what they want to hear, believe what they want to believe. And soon, folks discovered how to make money by betting rates would never change, much as they had bet on stability and certainty ahead of the ERM collapse.
US GDP in 1994 was 4.0%, unemployment was 5.5% and inflation 2.7%. Greenspan hiked rates 25bps to 3.25% in Feb 1994. Employment gains had been on a tear, and yet, somehow no one expected that rate hike. Naturally, he hadn’t pre-signaled a change. The bond market collapsed. Most people don’t think bond markets can crash, but that’s only because they haven’t traded long enough to live through one. Like all crashes, that one happened for all sorts of complex reasons, but the biggest was that the system was highly leveraged to a certain future.
Each interest rate cycle has been different of course. Over the decades, the Fed became increasingly transparent. That transformation was surely well-intended, seeking to reduce the risk of creating crises like that ’94 crash. But it is impossible to create certainty without also increasing fragility - that’s how markets work. As the system became more fragile, it required increasingly aggressive Fed intervention with each downturn. The process has been reflexive. Now markets move based on what policy changes the Fed says it may make in 18-30 months.
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Congress mandated that the Federal Reserve promote maximum employment, stable prices, and moderate long-term interest rates. That was in 1978. Unsurprisingly, the nation was reeling from years of high unemployment, rapidly inflating prices, and soaring long-term interest rates. In the decades since, the Fed has done a remarkably good job at meeting their specific mandate. But like all systems built to create certainty, stability, it has simultaneously produced profound fragility. This is most clearly seen in the need for ever more dramatic monetary interventions with each cyclical downturn.
Less obvious is the rising political fragility which is increasingly destabilizing the nation. Having tasked the Fed with producing economic prosperity by any monetary means necessary, our politicians then stepped away. They stopped governing effectively, fanned the flames of animosity, shielded from the adverse economic consequences of their dereliction of duty.
In each economic crisis, it was the Fed that provided leadership, forestalling collapse, but at a compounding cost. Now the nation approaches a point of peak economic and political fragility. And while it is easy to condemn the Fed for having enabled the decades of dysfunction, it is the political system that must bear the blame. But no matter, the Fed must soldier on, like a magnificent machine, attempting the impossible, delivering certainty without fragility, spinning ever faster to stand still.
And the greatest risk it now faces in meeting its mandate is an economic crisis accompanied by inflation. Such a crisis would force it to choose between a return to orthodox policy and the consequent defaults that would devastate asset prices, or a currency collapse and runaway inflation that rebalances the value of our assets and liabilities. Without a determined improvement in our politics, it is increasingly likely that we must endure the latter, followed by the former. And this drama will surely play out in the decade ahead.