After a jittery few days of trading, the markets stabilized a bit on Monday, though most economists are predicting a summer of volatility thanks to the Fed’s decision last week to announce that it would begin to “taper” its $85 billion a month asset-buying spree later this year if the economy stays on track.
The announcement is the first step in the end of “quantitative easing,” the program by which the Fed has been trying to goose markets, and keep borrowing rates low, for the past few years. Investors have been fearing this moment for some time, because bond-buying sprees often end badly, and this one is the biggest ever — meaning we are in uncharted territory.
But there are some historic case studies that give clues as to how QE may end. The smart folks at London-based Capital Economics recently looked at how major shifts in monetary policy played out in 1994 (during which time the bond market crashed) and in the early 1950s (when it didn’t). The good news is that, in their estimation, the conditions today look much more like those of the post–World War II period than those of the early 1990s.
As Capital notes, 1994 would seem to have many parallels to today: a longer-than-usual recovery, complicated by a prior housing collapse and a savings and loan crisis, and accompanied by a long period of low interest rates. But the differences were more important. For starters, once the economy did begin to strengthen at the end of 1993, it did so robustly, with GDP growth rising to 5%; that meant the Fed felt compelled to raise rates sharply and steadily. But rather than communicate all that clearly, the Fed was “bizarrely opaque,” according to Capital’s chief U.S. economist Paul Ashworth, saying only that it planned to take some actions that might result in a “small increase” in short-term money-market interest rates. In reality, monetary policy tightened considerably in 1994, with policy rates rising by 3 percentage points. Bond markets crashed, with two-year Treasury yields doubling to 8% within a year.
Bernanke, by contrast, is communicating frequently and clearly, letting investors know the exact unemployment targets to which the Fed is pegging its actions. He’s not looking to tighten rates for some time, but only to scale back asset purchases. What’s more, the Fed will be very unlikely to dump its major Treasury holdings on the market at any point in the next few years; in fact, it’s already said it’s willing to buy again should the market become “disorderly.”
Those conditions sound a lot more like the ones that existed during the period between 1942 and 1951, when America was dealing with an event even larger than the 2008 financial crisis: World War II and its aftermath. The bond-buying program then was nearly as large as today’s (the Fed’s holdings reached 11% of GDP in 1945, vs. 12% now, from a lower base). And it was arguably just as urgent. The 1940s version of QE was meant to keep borrowing costs low to finance the war effort.
Yet despite the massive run-up in the Fed’s balance sheet, things didn’t end badly. The unwinding was done in baby steps, as is the plan now, rather than all of a sudden. The Fed made it clear that it would do whatever it took to maintain “orderly conditions” in the security market (similar to Fed language today). And finally, rates were kept low long after the unwinding, not rising above 2% until 1955.
Of course, there are many differences in the markets today vs. the postwar period, and many more players and countries involved. Yet the lesson to take from the 1950s is that even large Federal Reserve buying sprees need not end in tears. And tapering doesn’t have to translate into a massive run-up in borrowing costs. Watch this space.
MORE: Market Reality Check