Exit is easy: Pt. 2

Gavyn Davies has an overly pessimistic column in the FT.  Here’s the intro and conclusion:

On Wednesday, the chairman of the Federal Reserve announced that the greatest experiment in the history of central banking might be nearing its end.  .  .  .

The exit from quantitative easing was always going to be long and arduous. There is no historical playbook for the central banks to follow. Like a fighter pilot who has experienced combat only in a flight simulator, the real thing might be very different. The central bankers are confident that they have the technical tools to finish the job but, as Mr Bernanke admits, it will be like landing that plane on an aircraft carrier, and possibly in stormy seas.

This is all wrong; it’s easy to exit monetary stimulus.  And indeed Davies shows this, even as he thinks he is showing the exact opposite:

The last big unwind – a much smaller one – started almost exactly a decade ago. On June 25, 2003 the Federal Open Market Committee met amid expectations of a cut in the interest rate from 1.25 per cent to 0.75 per cent.  .  .  .

Alan Greenspan was chief wizard at the Fed that day. Mr Bernanke, more radical than he is now, was there, but mostly stayed silent. The committee was fully aware of the dangers ahead when it decided to cut the federal funds rate by only 0.25 percentage points. The market concluded that the Fed was preparing to tighten policy sooner than expected, and sharply adjusted expectations for where it thought rates would be in the years ahead. The same thing happened this week.

Yes, and the economy was fine.  Davies continues:

The previous big Fed exit, announced on February 4, 1994, was even more dramatic. It was a day that triggered such turbulence that it is etched in the memory of all bond traders. Working as a Goldman Sachs economist, I was on the bond trading floor when the Fed released an innocuous-sounding statement. The FOMC had decided “to increase slightly the degree of pressure on reserve positions”‰.”‰.”‰.”‰which is expected to be associated with a small increase in short-term money- market interest rates”. Pardon? After a few moments, there was an explosion of noise as realisation set in.

The market was unprepared for the Fed change, Investors were over-leveraged and knee-deep in Mexican debt and mortgages. Equities emerged relatively unscathed. But before the bloodbath ended that November, the survival of the US investment banks was at stake.

The tipoff is the “equities emerged relatively unscathed” remark.  I’ve been around for 58 years and can’t recall a more boring and uneventful year than 1994.  That means Fed policy was working.  Boring is good!  Yes, there was some turmoil in the bond market, but bond markets don’t matter, what matters is NGDP.  And that was fine.

The sooner we remove finance from monetary economics the better.  All it does is lead to fuzzy thinking, as we also saw in my previous post.

Davies also discusses a botched exit, the Japanese monetary policy tightening of 2006.  But that wasn’t because exit is hard, but rather because they tightened policy after ten years of steady deflation.  The technical term for that policy approach is INSANE.  Why would you tighten monetary policy when prices have been falling for 10 years, and the bond market show no signs of inflation going forward?

And why would the Fed tighten monetary policy with 7.6% unemployment, 1.05% core PCE inflation (0.7% headline) and the TIPS markets showing 1.7% inflation over the next 5 years.  That’s also insane.

And let’s not even talk about the ECB in 2011.



16 Responses to “Exit is easy: Pt. 2”

  1. Gravatar of foosion foosion
    24. June 2013 at 07:51

    >>And why would the Fed tighten monetary policy with 7.6% unemployment, 1.05% core PCE inflation (0.7% headline) and the TIPS markets showing 1.7% inflation over the next 5 years.>>

    The 5 year TIPS spread is 1.58% at the moment. Throw in that inflation and inflation expectations are falling, as is employment/population.

    Totally insane.

  2. Gravatar of marcus nunes marcus nunes
    24. June 2013 at 08:36

    About 2003, GD gets it exactly wrong. In June 2003 VR made the famous presentation that opposed Bernanke´s QE proposing “forward guidance” instead. In the August 03 meeting it was implemented and with great success. Until then, even with interest rates dropping all the way to 1%, NGDP kept falling. At that precise moment it turned!

  3. Gravatar of John John
    24. June 2013 at 08:48

    I worry less about the exit than I used to because I just saw that Bernanke can lower price inflation just by hinting that there’s a small possibility that he might slowly taper sometime in the future if the economy is strong (which it currently isn’t). I think markets are studying Bernanke so hard that if he had a bout of constipation they’d sell of because he was tightening.

  4. Gravatar of Saturos Saturos
    24. June 2013 at 08:56


  5. Gravatar of Saturos Saturos
    24. June 2013 at 08:56

    Any chance of getting a response to Tyler Cowen?

  6. Gravatar of Rodrigo Escalante Rodrigo Escalante
    24. June 2013 at 09:05


    Being that inflation clearly will not be a problem in the foreseeable future, why is the Fed rushing to end their bond buying program? Wouldn’t low inflation present the Fed with more room to err on the side of caution by extending the stimulus until the economy has fully recovered, without having to worry about runaway inflation? Equity Markets have sold-off sharply in response to Bernanke, which is comparable with the Japanese reaction to BOJ. This being said, do you believe we could see Bernanke taking some of this into account and going back to their initial 6.5 unemployment target before tapering QE?

  7. Gravatar of Mikio Mikio
    24. June 2013 at 09:29

    Very good and entertaining post. I enjoyed reading it.

    The fact is that the Fed exits in 1994 and then in 2004 did lead to sustained gains in bond yields, but without derailing the equity bull markets – on the contrary.

    Which reminds me of an interesting coincidence – exits seems to come every 10 years, 1994, 2004, and now possibly 2014. Or is it not a coincidence?

    On a more serious note: I find it hard to believe that the Fed will begin withdrawing unless the economy begins picking up steam in coming weeks – which would be more or less miraculous, but not completely impossible.

    And everyone seems to have forgotten the Bank of Japan on the other side of the Pacific, which still has an open promise to do more “if necessary”. Japan is also the only major stock market that is actually up from 10 days ago – and the REITs sector actually rose even as China tanked today.

    Markets are a bit confused, as are many commentators, but I somehow don’t yet see a reason to turn bearish…

  8. Gravatar of Bababooey Bababooey
    24. June 2013 at 09:53

    NAFTA was signed in 1994.

  9. Gravatar of CA CA
    24. June 2013 at 10:41

    Scott was on Bloomberg radio this morning. Audio can be found here:


  10. Gravatar of Paul Paul
    24. June 2013 at 11:04

    Maybe it’s China’s foult and not the FED taper

  11. Gravatar of James in London James in London
    24. June 2013 at 11:20

    More evidence that given Bernanke’s impending exit, Stein’s bubble theories have the upper hand, from FT.com today:

    Mr Fisher made it clear he believed bubbles had developed in a number of financial markets, mentioning emerging markets and real estate investment trusts. He also noted that companies issuing bonds with a triple C rating, which is junk status, could now borrow for less than 7 per cent.
    “I think these [market movements] are things that are noteworthy. I was mentioning [them at last week’s meeting]. I wasn’t alone in drawing attention to these factors.”
    On the debt markets, he said: “We’ve had a 30-year bond market rally. These things do not go on forever.”

  12. Gravatar of ssumner ssumner
    24. June 2013 at 12:18

    foosion, Thanks, I’ll update it.

    Marcus, You are always ahead of me on the historical facts! Very interesting observation.

    John. Well Bernanke doesn’t smile very much. 🙂

    Saturos, I was thinking of a post. I agree with some of his points, but the first seemed off. Ddin’t he mean fiscal policy? Monetarists are skeptical of a mechanical relationship between NGDP and U, and Keynesians are skeptical of a mechaniscal relationship between M and NGDP, at least at the zero bound. Or did I miss his point?

    Rodrigo, I hope they do. My hunch is that the Fed is reluctant to quickly backtrack, and will only do so if the market carnage gets worse. Otherwise they’ll merely whisper some reassuring words.

    Mikio, Yes, and wasn’t 1984 another exit? And I agree it’s too soon to turn sharply bearish–the level of US stocks is still pretty high. I see 2% growth as far as the eye can see.

    Bababooey, And didn’t Kurt Cobain also die in 1994? But of course NGDP is all I care about–nothing else matters. 🙂

    CA, Thanks, I’ll put it in the next post.

    Paul, It’s both.

    James, Yeah, they were worried about bubbles in 1937 as well. I wonder if Bernanke mentioned that at the meeting.

  13. Gravatar of ssumner ssumner
    24. June 2013 at 12:23

    foosion, Actually it’s back to 1.64%, so I’ll just leave it be.

  14. Gravatar of Russ Anderson Russ Anderson
    24. June 2013 at 20:59

    Scott wrote: “And why would the Fed tighten monetary policy with 7.6% unemployment, 1.05% core PCE inflation (0.7% headline) and the TIPS markets showing 1.7% inflation over the next 5 years. That’s also insane.”

    I agree it is insane, but disagree that it wouldn’t be sporting to name names of those pushing insane tightening.

  15. Gravatar of Benjamin Cole Benjamin Cole
    24. June 2013 at 21:41

    I would like someone in the MM community to address the “problem” of the Fed selling off its $3.2 trillion booty hoard of bonds. The exit strategy.

    Is this a problem? Should they hold to maturity?

    Is the present GAAP accounting correct (that is, the Fed takes a “loss” if they sell the bonds below the purchase price, a “loss” that taxpayers must make up).

    IMHO, the Fed bought the bonds with cash it printed. It can’t suffer a loss. the bond sellers have been paid, they are happy, they made the transaction voluntarily.

    Would it not be better to say when the Fed sells its QE hoard, it has a “profit” and to pass that profit onto the Treasury?

  16. Gravatar of ssumner ssumner
    25. June 2013 at 05:02

    Russ, I’ve mentioned Taylor and Cochrane on numerous occasions.

    Ben, I would sell them off. Any losses are likely to be relatively small, compared to Fed profits over the years.

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