June 9, 2004
A popular variation of the famous George Santayana
quote is that “those who forget history are doomed to repeat it.”
In 1994, the Federal Reserve began increasing their federal funds
target from 3 percent to a high of 6 percent by early 1995.
Most of Wall Street believes this was a mistake.
A look at the historical record suggests otherwise.
The asset bubble at the end of the 1980s was in real
estate. Unfortunately, many
banks made loans against asset values that proved to be far too high.
When defaults developed, the very foundations of the banking system
were in doubt. (This bubble and its consequences, not the Gulf War, were the
real causes of the 1990-1991 recession.)
To restore earning power to the banking system, the
Federal Reserve engineered unusually low short term interest rates relative
to prevailing economic conditions. Bank
mergers were encouraged by bank regulators while bad assets were effectively
nationalized by the Resolution Trust Corporation (RTC).
While history might criticize some of these activities,
especially the asset disposal procedures of the RTC, the banking system was
relieved of serious financial stress and the recession was mild.
In 1994, the Federal Reserve decided to remove the
“subsidy” in short term rates that had improved the earning potential of
the banking system. They
decided to do so because bank profits were again healthy and most of the bad
debt had been absorbed by the U.S. Treasury.
Much has been made about Federal Reserve minutes that
suggested that an increase of 1.5 percentage points might be needed, but 3
percentage points ultimately occurred.
The fact that the initial 1.5 percentage point increase in short term
rates was met by an equal jump in yields on ten year government notes was
seen as a failure to communicate effectively with bond investors about the
change in Federal Reserve policy.
Also, the popular stock market averages stalled,
although equity values of smaller companies continued to expand rapidly.
However, if we remove our blinders from how the
financial markets reacted to the change in Federal Reserve policy, we can
see the foundations being laid for
the greatest surge in equity values during a four year period. We also can see inflation, which showed hints of intensifying
late in 1994, slowing from 2.1 percent as measured by the GDP deflator in
1994 to 1.3 percent in 1998.
After tax corporate profits, which already were rising
to 7.2 percent of corporate output in 1994, continued to ascend to a high of
more than 9 percent of corporate output by 1997. The growth of corporate
earnings never stalled even as equity values stuttered before surging.
To be sure, the higher interest rates slowed economic
growth. After jumping 4 percent
in 1994, real GDP gained only 2.7 percent in 1995. Housing activity declined temporarily. But no recession developed.
Indeed, economic growth jumped well above 4 percent
per year in the next six years.
Furthermore, the last 1.5 percentage point increase in
short term rates was accompanied by a 0.5 percentage point decrease in yields on ten year notes. Thus, the normal spread between overnight and 10 year
interest rates was restored. Mortgage
rates were again falling by the end of 1995, although they did not drop to
1993 levels until early 1998.
If there was an error in Federal Reserve policy, it was
caused by the frequent small changes in short term rates.
Moving more slowly in changing rates, as some Wall Street analysts
suggest should occur this time, probably would have added to investor
confusion and raised long term yields even higher.
It certainly would have preserved an inappropriate spread between
short and long term rates for a longer period of time.
Frankly, I used to tell my classes that Federal Reserve
policy between 1989 and 1995 was about as good as policy execution can get.
Economic performance in the subsequent four years certainly supports
Federal Reserve policy in 1994 was not a failure.
It was a magnificent success.