Dr. Yellen’s First Test
It has been a year since Janet Yellen took over as Chairman of the Federal Reserve, a position widely regarded as one of the most powerful and influential in all the world. It was a remarkably calm first year for Dr. Yellen, which stands in stark contrast to the experience of her predecessors. In fact, each of the last five Federal Reserve Chairman were tested with some type of political, economic or financial market turmoil not long after assuming the role.
Let’s take a look back at history.
Arthur Burns took over as Federal Reserve Chairman in February 1970. The U.S. economy had just slipped into an 11-month recession and was in the midst of a Bear Market that would shave off 37% of the value in U.S. equities by May 1970. In his early years, Burns pursued an easy monetary policy stance but was soon faced with a significant inflationary threat (1973 oil crisis) that required a tightening of policy. By the end of 1974, inflation was running at over 12% and during Burns’ tenure the consumer price index increased at an average rate of 9% per year.
G. William Miller assumed the Federal Reserve chairmanship in March 1978. He inherited an economy suffering from high inflation and took office as the stock market was in the midst of a Bear Market that had begun in 1976. Miller wanted to pursue a dovish policy as he took the view that inflation was not too high and would be self-correcting. However, his fellow governors did not share this view, and he was outvoted as they chose to raise the discount rate. Miller was blamed for a sharp decline in the dollar during his term and was criticized for his unwillingness to fight inflation. His tenure would be short-lived, lasting less than two years.
Paul Volcker became the next fed chairman in August 1979. Faced with the highest inflation rate the country had ever seen, Volcker hiked interest rates to over 20% in an attempt to end the period of stagflation that had plagued the 1970’s. Within a year of assuming the chairmanship, the U.S. entered the first leg of a “double-dip” recession. A second deeper leg of the “double-dip” recession accompanied by a Bear Market would start in 1981. By 1983, though, the economy was growing again and the inflation rate had moved all the way down to 3%. Volcker’s actions were widely credited with ending the stagflationary era.
Alan Greenspan’s tenure began on August 11, 1987. Greenspan would hike rates twice in the next month in his first and only aggressively hawkish actions in his nineteen years as Fed chairman. The 1987 crash would soon follow, with a total decline in U.S. stocks of over 35%. Greenspan quickly responded with a more dovish tone, stating that the Fed was “ready to serve as a source of liquidity to support the economic and financial system.” In time, his policy responses became known as the “Greenspan Put” and easy monetary policy was said to have played a large role in both the dot-com and housing bubbles.
Ben Bernanke’s chairmanship began in February 2006. The Fed was in the midst of a tightening cycle which Bernanke would continue in his first three meetings. The U.S. housing market would peak only a few months after he took over the role of Chairman, setting the stage for the worst recession and Bear Market in the U.S. since the Great Depression.
In late 2007, Bernanke reversed course and began an easing cycle that would continue throughout his tenure. The Fed Funds Rate was cut to an unprecedented 0% by December 2008 after which Bernanke began the first round of quantitative easing.
In late 2010, chairman Bernanke wrote of a virtuous “wealth effect” that would be created with easy central bank policy that focused largely on driving stock prices higher. The “Bernanke Put” was firmly established after he took immediate policy actions responding to stock market declines in 2010 (QE2), 2011 (Operation Twist), and 2012 (QE3). When Bernanke left office in January 2014, the Federal Funds Rate still stood at 0% while the Federal Reserve’s balance sheet had expanded to over $4 trillion (from $800 million when he first took office).
Janet Yellen’s tenure began in February 2014. She assumed the chairmanship during the fifth year of an economic expansion, no inflationary pressures, and an unprecedented period of calm in the financial markets. In his last act as Chairman, Bernanke started the process of slowly winding down the third round of quantitative easing. Yellen pledged to continue “tapering” the program over the remainder of the year. Importantly, she assured market participants throughout 2014 that interest rates would remain low for a “considerable period of time” even after the end of quantitative easing.
Dr. Yellen’s First Test
This brings us back to today. Unlike her predecessors, it has been smooth sailing thus far for Dr. Yellen. Her first year was spent winding down the asset purchase program and reaffirming her dedication to ultra-low interest rates, both widely anticipated policy actions. She has yet to be tested with any real market or economic turmoil.
In the coming months, that is likely to change as for the first time since 2011 market participants are anticipating a rate hike later in the year (currently September). The Fed itself, through its “dot plot” expectations, has also pointed to a potential increase in rates sometime in mid-2015.
The immediate test for Yellen will be how she responds to any market stress as the date of the first rate hike approaches. Back in 2010 and 2011 after stocks declined 17% and 21% when rate hike expectations became elevated, Bernanke quickly came to the rescue with new easing measures (QE1, Twist), dispelling any notion of an imminent rate hike. Market participants applauded these measures, expectations for rate hikes were pushed out, and stock prices raced to new highs.
For Dr. Yellen, a similar response may prove more difficult as we are now six years into the recovery and there is a growing chorus of observers arguing that keeping rates at 0% may be doing more harm than good (see Bill Gross for one example, where he said recently that the Fed needs to raise rates to “save capitalism”). While the stock market has more than tripled under 0% policy, the “wealth effect” that Ben Bernanke often preached about remains illusory for most. As such, it is becoming increasingly clear to many that the Fed has been primarily serving the short-term interests of the financial markets in recent years, perhaps to the detriment of the real economy.
That is not to say that the path to normalization will be easy. Most certainly it will not as the federal government, the stock market, and certain areas of the economy have become addicted to artificially low interest rates and will not be happy with a change in policy. But therein lies the test. How Dr. Yellen responds will begin to define her record as chairman and whose interests she is serving. Will she continue the “Fed Put” policies of the last two chairman or follow her own path? At the next FOMC meeting and press conference on March 18 we should have a clearer indication.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of two award-winning research papers in 2014 on Intermarket Analysis and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
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