Fed To Leave Interest Rates On Hold For A Long Time?

The table below from the Federal Reserve of Atlanta is interesting. It looks at all the recessions since 1970, and how long it took for unemployment to peak after the recession technically ended, and how much longer after that that the Fed actually started to tighten up. The short 1980 recession, which was really the first part of a double-dip recession, is excluded.

Note that unemployment always peaks after the recession is over. However, in earlier recessions the time lag between the end of the recession and the peak of unemployment was brief. This sort of holds for the 1970 recession as well, since there was a double peak in unemployment (6.1%) in both December of 1970 and in August of 1971. If the first peak were used, the time from the end of the recession to the unemployment peak would have been just one month, and to the start of the tightening by the Fed would have been 15 months.

The last two recessions were very different, with unemployment continuing to rise for more than a year after the end of the recession. Both were very mild recessions.

In all cases, the Fed waited a significant time (a minimum of six months) after the recession was over before they took their foot off the accelerator.

If we assume that the recession technically ended in July, something that would be indicated by the rise in Industrial Production and Capacity Utilization that started then, and we followed the same path as the 1991 recession, then we would not see unemployment peak until October 2010 — and not until February 2011 if we were to follow the path of the 2001 recession.

If anything, the dynamics of this downturn are going to argue for an even much slower recovery this time around than we had in the last two recessions. For starters, the amount of wealth that has been destroyed in this downturn dwarfs that of the previous two. The consumer was much more deeply in debt, and the decline in the value of his assets have left him even more leveraged today than he was before the recession started.

Also, the savings rates going into the previous recessions were much higher. While the banking system was wounded in the 1991 recession (S&L crisis), it was but a mere scratch when compared to the crisis of a year ago.

Given the historical precedents, if we followed the path of the 1991 downturn, the Fed Funds rate would not rise until June of 2012, and if we followed the 2001 precedent, the Fed Funds rate would not rise until May of 2012. Even if we were to follow the earlier precedents, it would be February of 2010 (1982), September of 2010 (1974-75), or October of 2010. Well, we are more than a month passed July, and we know that we have not hit the unemployment peak yet, so I think it is safe to throw that one out.

The problem with the Fed leaving interest rates too low for too long is it tends to help create bubbles. An overly easy monetary policy also can let inflation get out of hand. The ultra-low interest rates in the early part of this decade played a key role in allowing the housing bubble to form.

I really don’t see much evidence of any current bubbles. Yes, the stock market does seem to be pricing in a much stronger recovery than I foresee, but it is not really at a bubble stage. Oil and other commodity prices are well off their lows of last winter, but also well below the highs seen in the summer of 2008. Real estate is clearly not in a bubble anymore.

One could make a case for bonds being in a bubble — certainly prices are high and yields are very low by historical standards. However, over the past year, the CPI is actually negative, and hence real rates are higher than nominal rates. At the headline level that will not last, the decline in oil prices is going to anniversary, so year-over-year headline inflation will head up.

However, excluding food and energy, prices are likely to stay very well contained. The most important component of the CPI, especially core CPI, is housing prices. No, not the price of your house, but what the government figures you are paying yourself for the privilege of sleeping in your own bed, otherwise known as Owners Equivalent Rent. Together with the regular rent that renters pay their landlords, that makes up about 30% of the overall CPI and about 40% of core CPI. Vacancy rates are rising and rents across the country are under pressure. This means that overall inflation, particularly core inflation, will stay low.

There is a chance, however, that this policy could start to develop a bubble in stocks. There is a lot of money that has been pushed into the system. There is not that much demand by corporations — especially the solvent ones that the banks would like to lend to — to borrow lots of money to build new plants, or even take on more inventory. That money will try to find a home, and if it can’t find it in the real economy, it will gravitate to the financial economy.

Thus, while keeping rates low does pose a risk, that risk looks mostly theoretical at this point. The very low Fed Funds rate means that there will also be a very steep yield curve.

This is good news for the banks, since their core economic function is to borrow short term - for example by taking in checking deposits — and to lend long term, for example making commercial and industrial loans. This will help big banks like J.P. Morgan (JPM) and Citigroup (C) earn enough from their current loans to help offset the massive losses they have hidden on other books of previous loans that have gone bad.

Historical lag between end of recession, unemployment rate peak, and beginning of funds rate tightening cycle

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