Can the Fed navigate the Next Hairpin Turn?

Cartoon by Jim Gibson

On May 21 of this year I posted “Inflation History Lesson: From the Frying Pan to the Fire and Back Again”. In that post I used data from the last four US recessions going back to the 1980s. The data supports the view that Fed policy is much too bumpy and it waits much too long after the end of each recession to turn off the monetary hoses. The result is that policy jerks us around between inflation and recession.

Our prime preoccupation today is when the Fed will ease off the accelerator pedal. Markets are edgy. Economic agents are uncertain about how to buy and sell and invest. In today’s post I focus on those same four recessions with particular interest in how interest rates behaved after the Fed started raising interest rates. It took the Fed a while each time, but once it declared the economy strong enough the Fed began reversing its stimulus and started raising rates. It is instructive to know following three of these recessions the result was a rise in policy rates, a subsequent rise in market interest rates, and the expected decline in the housing market. It is instructive because we have choices now following the end of the fourth recession. We can immediately begin to reverse policy and try for a gradual return to normalcy or we can wait until we are 100% sure about the economy and incur a sharp and painful reversal.

The housing sector is one of the glowing parts of our economic recovery today. It would not bode well if an abrupt change in policy threatened that. My look into three past recessions suggests that we need to get the policy reversal going soon because waiting may throw us back into the frying pan! I begin by discussing interest rate and housing spending for each of the past four recessions. A table at the bottom of this post summarizes all the data discussed.

In the recession that ended in November of 1982, the FFR (Federal Funds Rate) was kept low until March of 1988.  Low in those days was 6.6%. During those six years of economic recovery and expansion the FFR was not allowed to rise above 6.6%. But by spring of 1989, the FFR had increased to 9.4%. In one year the policy rate increased by 280 basis points. In that same year the Treas10 (rate on the 10 year Treasury Bond) rose by 99 basis points to 9.36% and the Mort30 (30 year mortgage rate) increased by 112 basis points to 11.1%. ResCon (Residential Construction Spending had been rising at 5.7% in the two years before March of 1988. In the next 8 eight quarters ResCon fell by -2.3%. In six of those eight quarters ResCon declined.

In the recession that ended in March of 1991, a similar pattern emerged. It took three years after the end of the recession for the Fed to allow its policy rate to rise. The FFR was at 3.3% in Spring of 1994 but almost doubled to 6.1% by Spring of 1995.  The Treas10 increased by 150 basis points to 7.5% and the Mort30 rose by 170 points to 8.8%. ResCon which had been growing by 10% for the past eight quarters slowed to growth of only 2% in the next two years. During those two years. ResCon fell in three of those eight quarters.

In the recession that ended in November of 2001 rates again took three years to rise. In November of 2004 the FFR was 1.9%. By summer of 2006 the FFR had risen to 5.3% -- an almost tripling of value in about 1.5 years. Market rates followed. The Treas10 rate rose by 90 points to 5.1% and the Mort30 rose by 103 basis points to 6.8%. ResCon which had grown by about 10% in the two years before grew by 0% in the two years after rates began rising. In three of those eight quarters ResCon fell.

Our last US recession ended in June of 2009 – just a little over four years ago. The FFR has remained at 0.25%. Market rates are about as low as they have ever been with Treas10 at 2.6% and Mort30 at 4.4%. Housing is booming in the last eight quarters at a rate of about 9%. The big question is what will happen next.

What we hope is that the Fed can navigate this next hairpin turn better than history suggests. The Fed cannot go much longer than four years before it reverses policy. We all know the policy change is coming. Optimistically, the Fed could taper and then reverse policy over the coming months with gradual increases in interest rates without damaging the growth in housing. If this policy change is warranted by a strengthening economy, then the sources of this strength might keep spending growing despite rises in interest rates. Less optimistically, once policy is reversed expectations will drive interest rates much higher and this will severely crimp housing and other forms of interest-sensitive spending and an overall economic slowdown will ensue. It seems to me that the longer the Fed waits to adjust for the coming turn, the more likely the economy will go into another spin. Getting on with the taper seems the least risky course of action.

Table: Interest Rates and Housing after

The Last Four US Recessions

Recession Ended			Nov-82
FFR floor			Mar-88		6.6
FFR Peak			Spring 89		9.8
Treas10 Peak			Spring 89		9.4
Mort30 Peak			Spring 89		11.1
ResCon Avg/Neg			2 years  before		6/3
ResCon Avg/Neg			2 years after		-2.3/6
Recession Ended			Mar-91
FFR floor			Feb-94		3.3
FFR Peak			Spring  95		6.1
Treas10 Peak			Spring  95		7.5
Mort30 Peak			Spring  95		8.8
ResCon Avg/Neg			2 years before		10/0
ResCon Avg/Neg			2 years after		2/3
Recession Ended			Nov-2001
FFR floor			4-Nov		1.9
FFR Peak			Summer 06		5.3
Treas10 Peak			Summer 07		5.1
Mort30 Peak			Summer 08		6.8
ResCon Avg/Neg			2 years before		10/0
ResCon Avg/Neg			2 years after		0/3
Recession Ended			June 2009
FFR floor			Now		0.25
FFR Peak			???		???
Treas10			Now		2.6
Mort30			Now		4.4
ResCon Avg/Neg			2 years before		9/0
ResCon Avg/Neg			2 years after		???