Fed Concern With Repeat of 1937 Blunder Echoed by Markets

By Matthew Boesler  

Photographer: Price Chambers/Bloomberg

Chicago Federal Reserve President Charles Evans said in a Sept. 24 speech that he... Read More

The specter of 1937 is weighing on the minds of top Federal Reserve officials as they work on a road map for unwinding their unprecedented economic stimulus.
That was the year, following a recovery from the Great Depression, that the Fed prematurely tightened monetary policy and was forced to backtrack as the economy fell back into a recession.
The dangers of repeating that mistake are highlighted in a survey of the 22 primary dealers that trade U.S. Treasuries directly with the Fed. The dealers saw a 20 percent chance the Fed, which plans to raise its main interest rate in 2015, would be forced to cut it back to
zero within two years, according to the median response to the poll, taken by the New York Fed before September’s Federal Open Market Committee meeting.
“When I think of the odds of them having to reverse course, they are uncomfortably high because this is not your typical cycle and typical recovery,” said Eric Green, head of U.S. rates and economic research at TD Securities USA LLC in New York, a primary dealer.
The fact that the New York Fed’s poll even raised the question of a return to zero interest rates shows that officials have doubts about tightening policy, said Green, a former New York Fed economist.

Seeking Affirmation

“When the central bank asks me that point blank -- what are the odds -- I also realize that while these guys have the confidence to take policy higher in terms of rates, the level of certainty is far less than usual,” he said. “They are looking for affirmation desperately, wherever they can get it, that it’s the right thing to do.”
The Fed received the survey results Sept. 8 and published them Oct. 9.
New York Fed President William C. Dudley and Chicago Fed President Charles Evans in recent weeks have invoked the lessons of 1937 as reason for caution as the central bank prepares for the first interest-rate increase since it lowered its benchmark federal funds rate to zero in 2008.
“I believe that the biggest risk we face today is prematurely engineering restrictive monetary conditions,” Evans said in a Sept. 24 speech in Washington. “The U.S. experience during the Great Depression -- in particular, in 1937 -- is a classic example for monetary historians.”
After a return to growth and inflation led the Fed to raise bank reserve requirements, and the government to reduce deficit spending, “the economy dropped back into recession and deflation,” Evans said.

‘Horrible Mistake’

Dudley, answering questions at the Bloomberg Markets Most Influential Summit in New York Sept. 22, said premature tightening in the 1930s “turned out to be a horrible mistake. It’s actually characterized as the mistake of 1937.”
Policy makers at their September meeting discussed possible reasons why futures markets suggested a path of interest-rate increases far below Fed officials’ own published projections. One explanation offered at the meeting: traders were placing “considerable odds” on the possibility that the federal funds rate would revert to zero within two years of the first increase, according to the minutes.
Eurodollar futures currently imply a federal funds rate of 2.32 percent at the end of 2017, well below the 3.75 percent median projection in Fed policy makers’ most recent forecast, published in September. The probability that the Fed’s benchmark rate will be below 1 percent by the end of 2017, derived from options on eurodollar futures contracts, is 17.3 percent, up from 11.4 percent six months ago.
Trading in the futures markets reflects “a chance that it doesn’t get a full hiking cycle, plus also maybe even cutting” of the benchmark rate in the next few years, said George Goncalves, head of interest-rate strategy at Nomura Holdings Inc. in New York, a primary dealer.

1937 Parallels

One big concern weighing on the market-implied rate path is the outlook for growth worldwide. Here, there are parallels with the global backdrop in 1937, said Steven Ricchiuto, chief economist at another primary dealer, Mizuho Securities USA Inc. in New York.
“Then, you had a world of excess supply of tradable goods, and now, you have a world of excess supply of tradable goods,” said Ricchiuto. “We’ve created a world where we have produced an enormous amount of growth in the emerging world with one model: export to growth. And the problem is, who are you exporting to?”

Limited Inflation

Global weakness and a rising dollar may reduce demand for American exports and keep a lid on inflation. The Fed’s preferred measure of prices, the personal consumption expenditures index, rose 1.4 percent in September from a year earlier, falling short of the central bank’s 2 percent target for the 29th straight month, according to Commerce Department figures released Oct. 31 in Washington.
The core price measure, which excludes fuel and food, rose 0.1 percent in September from the prior month and was up 1.5 percent from a year earlier. Year-over-year gains have held at that level since May.
Declining inflation strengthens the case for avoiding premature tightening, said Gauti Eggertsson, an economics professor at Brown University in Providence, Rhode Island and former New York Fed economist.
That wasn’t an issue in 1937. Then, “people were worried about excess inflation, but now, there’s not even that,” Eggertsson said. “Inflation has been running very low and is projected to be low going forward, so there is even less reason to be tightening.”

Sweden’s Cut

Recent actions by other central banks underscore the desire of Fed officials like Dudley and Evans to take a cautious approach to removing stimulus. Sweden’s central bank last week cut its benchmark rate to zero, the third phase of easing in less than a year, following premature rate increases in 2010 and 2011.
Sweden isn’t alone in having to reverse tack in recent years. The European Central Bank raised rates in 2008 and twice in 2011 to combat inflation that quickly evaporated, and the euro area now faces its third recession in six years. Sweden’s Riksbank and the ECB echoed mistakes by the Bank of Japan in 2000, when policy makers raised the key rate, only to cut it six months later as deflation set in.
Still, markets may be exaggerating the risk of rates reverting to zero after premature tightening, according to Michael Cloherty, head of U.S. interest-rate strategy at Royal Bank of Canada’s RBC Capital Markets unit in New York, a primary dealer.
A more likely scenario is that Fed policy makers begin raising rates “and then go on an extended pause rather than U-turn,” he said.