BIZMOLOGY — As the Federal Reserve reduces its stimulus program in light of the improving US economy, some observers are concerned that inflation could skyrocket while long-term bond rates stagnate. Although that did happen in two similar situations after the Great Depression and after World War II, the Fed operates quite differently today than it did then.
To understand why the Fed’s current course seems likely to keep the US economy on a steadily improving course, it’s important to compare those times with now.
As we know, the Federal Reserve began one of the most aggressive stimulus programs in its 100-year history in March 2009 to put downward pressure on interest rates and bolster the beleaguered US economy. Known as quantitative easing (QE), the Fed essentially initiated a large-scale asset purchase of treasury and mortgage-backed securities. Though many have perceived QE as an unprecedented action in US history, it is extraordinary but not entirely unprecedented.
The Great Depression and the Post-War Economy
Twice before in US history, the Fed’s balance sheet reached 20% of nominal Gross Domestic Product (GDP) — during the Great Depression and post-World War II. (For comparison purposes, Figure 1 shows the Fed’s balance sheet in relative terms. )
We’ve been here before, so what?
Previous Fed actions may help to shed some light on the timing of crucially important economic benchmarks such as long-term bond yields. Prior to the Federal Reserve’s aggressive actions in 1940 and 1946, long-term government yields traded within a normal range of 2.5% to 4.5%. Yields hit rock bottom in the summer of 1941 and remained low for the next 18 years. It wasn’t until 1959, after a period of significant US economic expansion, that yields returned to prior highs (see figure 2).
Historically, not only did yields creep up slowly but inflation exploded almost immediately. Double-digit inflation was reached in 1942 and again in 1947 — three years and two years, respectively, after the Fed’s balance sheet hit 20% of nominal GDP. Although inflation currently remains subdued, some believe that high inflation is on the horizon.
As QE comes to a close, does it mean history will repeat itself?
Before we draw dramatic conclusions between the two time periods and assume yields will remain low for long periods of time and high inflation is inevitable, it’s important to note the Fed was operating under distinctly different circumstances in the 1940s and today.
During World War II, the Fed abdicated its responsibility for monetary policy and followed the demands of the US Treasury Department, which tasked the Fed with keeping rates low so that the US could finance its growing debt from World War II. After the “the 1951 Accord” between the Fed and Treasury, the Federal Reserve regained its independence. Economically, the two time periods are very different as well: The financial sector is much more deregulated today and the US economy is much more globally integrated.
While today’s circumstances pose different challenges, the Fed is also equipped with new tools. In 2006 the Federal Open Market Committee (FOMC) was authorized to pay interest on reserves, required and excess, effectively creating a potential incentive for financial institutions to keep excess money out of the economy and, thereby, limiting the total money supply.
Money that remains in the form of excess reserves is isolated from the real economy, and the effect on inflation is negligible. This, along with other tools, may allow the Fed to decrease the size of its balance sheet over time while keeping inflation under control.
Will interest rates remain low for the foreseeable future? Will inflation skyrocket as it did in the 1940s? No one knows exactly what the future holds. But with history on its side and a new set of tools, the Fed may actually have more control on the future than perceived by the outside world.