Summit Series Forums 2017
The Federal Reserve: two centuries of lessons learned
Bob Baur Executive Director & Chief Global Economist Principal Global Investors To see tomorrow…
“The most reliable way to forecast the future is to try to understand the present.”
-John Naisbitt, author of Megatrends
2 Agenda The Federal Reserve
• How did it come about? – U.S. central bank history • What guides Fed policy? – Markets, economy, inflation, Taylor rule • Lessons learned – Brought “Great Moderation” – Then, more lessons • How to normalize policy? – Yet another lesson
3 Central banks always controversial
“No business expansion in 40 years has died of old age. The Fed has murdered every one of them.”
-Rudiger Dornbusch, MIT economics professor 1997 (paraphrasing)
“The bank is trying to kill me, but I will kill it.”
-U.S. President Andrew Jackson, 1836
4 U.S. central banking A checkered history
• First national currency 1775 • Bank of North America 1782 • First Bank of the United States 1791 to 1811 • No central bank 1811 to 1816 • Second Bank of the United States 1816 to 1836 – Panic of 1837 • Free banking era 1837 to 1913 – Lots of banks, few standards, many panics
5 U.S. central banking More checkered history
• National banking 1863 to 1913 – System of national banks – High standards for bank reserves – Created national currency – Financed U.S. Civil War – Still, periodic liquidity crises • Panics: 1857, 1873, 1893, 1907
6 Then the Fed The Federal Reserve Act of 1913
• Conceived: Jekyll Island, Georgia 1910 • Key provisions – Board appointed by President – Decentralized over 12 Districts – Lender of last resort – Government issues money • No last resort lender 1930s • Low fixed rates to finance WWII • Fed independence 1951
7 Fed policy guide: economy Fed’s initial key policy rate
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10 US Recessions 8 Fed discount rate 6
4
2
0 1914 1917 1920 1923 1926 1929 1932 1935 1938 1941 1944 1947 1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016
Source: Federal Reserve Board; National Bureau of Economic Research; Principal Global Investors. 8 Modern fed funds rate
20 18 16 14 US Recessions 12 Effective fed funds rate 10 8 6 4 2 0
Source: Federal Reserve Board; National Bureau of Economic Research; Principal Global Investors. 9 Policy guide: inflation
20 US Recessions 18 Effective Federal Funds Rate 16 Headline PCE Prices YoY% 14 12 10 8 6 4 2 0 -2 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Source: Federal Reserve Board; National Bureau of Economic Research; Principal Global Investors. 10 Policy guide: stock market
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S&P 500 index lhs 13 Fed discount rate rhs 11
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7
5
3
19 1 1951.02 1953.02 1955.02 1957.02 1959.02 1961.02 1963.02 1965.02 1967.02 1969.02 1971.02 1973.02 1975.02 1977.02 1979.02 1981.02
Sources: Robert Shiller’s S&P 500 Index, Federal Reserve Board, Principal Global Investors. 11 Policy guide: stock market
14 S&P 500 index lhs
Effective fed funds rate rhs 12
10
900 8
6
4
2
90 0 1982.07 1985.01 1987.07 1990.01 1992.07 1995.01 1997.07 2000.01 2002.07 2005.01 2007.07 2010.01 2012.07 2015.01 2017.07
Sources: Robert Shiller’s S&P 500 Index, Federal Reserve Board, Principal Global Investors. 12 What guides Fed policy? Signposts
• Economic growth • Inflation • Stock market • Taylor Rule – Adherents: Volker, Greenspan – FFR = Inflation + neutral real rate + α(inflation gap) + β(output gap) • Fed reacts; doesn’t anticipate
13 Lessons learned
• Solving one problem at a time – Liquidity panics 19th century • Frequent panics, recessions • National banking – Bank runs 1930s • Deposit insurance – Inflation 1970s • Focus on money supply • High real interest rates • Measure of success
14 The “Great Moderation” U.S. real gross domestic product 16
14 US Recessions Real GDP YoY% 12 10 8 6 4 2 0 -2 -4 -6 1948 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Sources: Robert Shiller’s S&P 500 Index, Federal Reserve Board, Principal Global Investors. 15 More lessons… To be learned
• Greenspan: central bank put – High confidence creates more risk-taking • Insufficient oversight 2000s – Government-sponsored housing loans – High leverage – Dodd-Frank bill • Exchange rates fixed to U.S. dollar – Dollar-denominated loans 1990s – Global issues: late 2015, early 2016
16 One more lesson… How to get back to normal policy?
• Long-term rates approximate potential growth – Population growth: 0.5% to 0.75% – Productivity growth: 1.5% – Inflation: 2% – Normal yield: 3.5% to 4% – Upward pressure on long-term yields • Unintended impact of years of ultra-low rates… – Very high valuations – Hard to normalize
17 What can the Fed do? Difficult choices
• How to normalize rates... – Without deflating stock markets • Can it be done? – Depends on low inflation – If long-term treasury yields stay at 2.25% • But, 4% nominal growth says yields must rise – Government bonds very expensive – Stocks, rates rise together for a while
18 The last investment cycle
Boom: 1982-2000. Good growth, mild inflation; gain=1236%. 900 Start P/E=6-8 End P/E=29
Bust: 2001 – 2016. Deflation, Transition: 2016-?? financial crisis, fear, weak Stock prices ahead investment, wage stagnation, of earnings. political change 2008, 2016, 2017 P/E=23-24 13 years of no gain. 90
Sources: Robert Shiller’s S&P 500 Index, Principal Global Investors. 19 Possible outcomes
Years of ultra-low rates pushed P/E to 23-24; earnings need time to catch up
Transition: 2016-?? 600 Bust: 2001 - 2016 2000.03 2002.09 2005.03 2007.09 2010.03 2012.09 2015.03 2017.09 2020.03 2022.09
Sources: Robert Shiller’s S&P 500 Index, Principal Global Investors. 20 Roadmap If interest rates rise…
• Robust financial returns may be hard to find – Government bonds expensive – Stocks, rates rise together for a while • Higher rates bring equity correction • Correction brings long rates down – No net progress in stock markets • Rally, correct, rally, correct • Where are the returns?
21 Fed policy Depends on inflation
• Robust synchronized world expansion – Suggests upward pressure on inflation – Fed hikes in December – Gradually shrinks bond portfolio – Two hikes in 2018 – More hikes depend on stock market – ECB follows suit in January – BOJ raises ten-year yield target mid-2018
22 Longer-term roadmap Possible implications
• Central banking, politics always intertwined • Economy may do better than financial markets – Central banks accommodate faster growth – No obvious excesses • Slow return to normal policy • Active managers outperform passive • Financial risks are in developing countries
23 Thank you Important Information
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