Ben Bernanke is not the first Federal Reserve chairman to send a message that investors took as unduly hostile, thwarting a strong stock-market rally even as a financial storm brewed in Asian emerging markets.
In early 1997, deeming the U.S. economy on a sturdy growth course, Fed Chairman Alan Greenspan surprised the market with a quarter-point boost in short-term interest rates – despite inflation levels that the Wall Street Journal editorial page said required “a microscope” to see.
When Greenspan acted in March 1997 – just a few months after his famous musings about how to diagnose “irrational exuberance” in financial markets – the Standard & Poor’s 500 index had been on a roll, having gained 21% over the prior six months. Investors threw a bit of a fit at having Greenspan disturb their party, dropping the stock benchmark by 6.7% over a few weeks before it rebounded to surge powerfully to new highs through July.
This Fed-induced gut check didn’t do much lasting damage for a couple of reasons. First, the U.S. economy had good momentum, with growth above 4% for the whole year. Second, Greenspan’s dose of tough love didn’t coincide precisely with the “Asian Contagion” financial crisis but preceded its earliest stirrings in the market for Thailand’s currency by a couple of months.
A time more different than similar
We are, of course, in a time more different than similar, a post-crisis U.S. economy being treated by unprecedented monetary therapies. And such historical analogies never match perfectly: Consider that, until very recently, this cheery 1995 example seemed apt.
Yet when Bernanke last week conveyed a plausible timeline for easing back on the “quantitative easing” asset-buying program and perhaps ending it within a year if the economy improved, it was likewise viewed as less friendly than traders expected and hoped.
Given very low recent inflation data and the continued overhang of restrained government spending, the common view seemed to be that Bernanke possessed – but dismissed – some perfectly valid excuses to appear more willing to maintain the Fed’s extraordinary money-creation pace.
Like Greenspan 16 years ago, Bernanke and his colleagues have been wary of signs of overconfidence among investors, especially in the credit markets, which Fed officials have described as showing pockets of excess from “yield-chasing” activities. At least in part, Bernanke’s serious pose about ending QE was aimed at skimming some froth from markets before things got too thick. As it happened, before Bernanke spoke last Wednesday, the S&P 500 had gained 22% since the mid-November low, almost exactly the same six-month win streak that preceded Greenspan’s ’97 effort.
The key differences today versus 1997 suggest that the current Fed will be on high alert for acute market stress and quick to send a soothing message:
First, unlike in ’97, the Fed seems to have slightly greater confidence in the strength of economic growth than does the twitchy market consensus. This is one explanation for stocks’ sour response to what otherwise would be good news: The Fed thinks growth is good enough that the economy needs less help, and that monetary policy and interest rates can “normalize.”
While true that the rapid rise in 10-year Treasury yields above 2.6% is on some level a reaction to the Fed’s assessment of a firmer economy, the economic data have not accelerated in recent months anywhere near as quickly as yields have shot higher.
In fact, some time-worn indicators of future Fed policy are hinting that conditions are closer to the sort that tend to trigger more Fed easing rather than less. Expectations of inflation over the next five years implied by inflation-protected Treasury prices have rolled over hard and are near the levels that have preceded new Fed stimulus plans over the past few years.
Doug Ramsey, strategist at the Leuthold Group, also notes that the recent path of the ISM manufacturing index – hugging the 50 line approximating stagnation – has historically been associated with imminent Fed easing.
He adds that the past 15 years of bubble-and-bust cycles “have rendered old relationships between financial markets and the real economy less reliable.” As such, “We’re not inclined to take the call for Fed easing at face value. But we can’t help wondering whether economic measures have taken a back seat to asset prices in the formulation of Fed policy.” This could explain Bernanke’s emphasis on a potential exit – and would also mean that further nasty market action would change his tune promptly.
The Asian tumult today is a clearer and more present danger. The near seizing-up of Chinese interbank lending, widespread currency declines in emerging markets and popular uprisings in part due to inflation in many countries are happening now. In 1997 the currency crisis played out over quite a number of months, culminating for American investors in a 10% one-day collapse in the Dow Jones Industrial Average that October.
That ingrained in longtime investors’ minds the fact that U.S. markets cannot remain indefinitely insulated from panicked capital flows in and out of emerging economies. This is worth keeping in mind given the fact that the S&P 500 has so far this year outperformed the bellwether iShares MSCI Emerging Markets Index (EEM) by more than 25 percentage points.
Another key difference between today and 1997 is that, in 1997, policy makers could not look back upon 16 years worth of successive market crises and central bank intervention and experimentation as dense as we’ve since witnessed. This also argues that the Fed will keep markets and the economy under intensive monitoring for stresses with these experiences in mind.
For better or worse, the present chairman is a co-author of a Wall Street Journal article from early 2000 called “What Happens When Greenspan IS Gone?” The opening line is: “U.S. monetary policy has been remarkably successful during Alan Greenspan's 12 1/2 years as Federal Reserve chairman.”