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Weekly Commentary: No One Knows How Monetary Policy Works

Weekly Commentary: No One Knows How Monetary Policy Works

My interest was piqued by a Friday Bloomberg article (Ben Holland), “The Era of Cheap Money Shows No One Knows How Monetary Policy Works.” “Monetary policy is supposed to work like this: cut interest rates, and you’ll encourage businesses and households to borrow, invest and spend. It’s not really playing out that way. In the cheap-money era, now into its second decade in most of the developed world (and third in Japan), there’s been plenty of borrowing. But it’s been governments doing it.”

I remember when the Fed didn’t even announce changes in rate policy. Our central bank would adjust interest rates by measured bank reserve additions/subtractions that would impact the interbank lending market. Seventies inflation forced Paul Volcker to push short-term interest-rates as high as 20% in early-1980 to squeeze inflation out of the system. 

Federal Reserve policymaking changed profoundly under the authority of Alan Greenspan. Policy rates had already dropped down to 6.75% by the time Greenspan took charge in August 1987. Ending 1979 at 13.3%, y-o-y CPI inflation had dropped below 2% by the end of 1986. Treasury bond yields were as high as 13.8% in May 1984. But by August 1986 – yields were down to 6.9% – having dropped almost 700 bps in 27 months.  

Lower market yields and economic recovery were absolute boon for equities. The S&P500 returned 22.6% in 1983, 5.2% in 1984, 31.5% in 1985, 22% in 1986 – and another 41.5% for 1987 through August 25th. Markets had evolved into a speculative bubble.  

One could pinpointing the start of the great Credit Bubble back with the 70’s inflation. For my purposes, I date its inception at the 1987 stock market crash. At the time, many were drawing parallels between the 1987 and 1929 market crashes – including dire warnings of deflation risk – warnings that have continued off and on for more than three decades.  

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