Antonio Fatas has a new blog post up about the potential market response to the reversal of the current Quantitative Easing program that the Federal Reserve is undertaking.
The point I made earlier is that the more likely scenario for tightening of monetary policy is that this will happen when growth gets stronger. Krugman makes the same point in his latest post. But I can also see plenty of articles taking a much more pessimistic view and describing all the bad things that will happen when central banks change their current monetary policy stance from expansionary to neutral, including a large downward adjustment to stock markets. I am surprised that there are very few historical references in those articles, so let me produce two to refresh our historical memory…What has happened to the stock market in previous cycles after the central bank decided to abandon its policy of low interest rates and start raising those rates?
Focusing on the ‘last two’ episodes of interest rate hikes (1994 and 2001), Fatas concludes that:
“Initially the stock market moves sideways. During the first year there are gains of about 1%. But the years that follow, and once the increases in interest rates have stopped we see large increases in the index — interest rates stopped increasing in the first episode 12 months after they started going up; in the second episode it happened about 24 months later. This is more or less when the stock market starts its climb.”
I have a couple of (related) issues with this argument. First, there is a distinction between strong growth (with, presumably,) inflationary pressure driving an interest rate hike and a decrease/halt to a bond-purchasing program that does not lead to an interest rate hike. In the latter scenario (the situation under discussion today), our economy remains under potential, unemployment remains elevated, and it is not clear how the underlying growth momentum in the economy compares to either 1994 or 2004.
Secondly, because we are talking about an end to QE and not a hike in the interest rates, I actually think the relevant historical episodes are the end of QE1 and QE2 in 2010 and 2011.
Neither of these recent episodes led to the continued growth in the real economy or the Dow that we saw after the 1994 or 2004 rate hikes. In 2010, after the end of QE1, the Dow dropped nearly 11% before recovering to roughly the same level as the end of QE1 by the start of QE2. Similarly, the Dow dropped over 14% after the end of QE2, only to recover to a level slightly above where it began at the end of QE2. So, in both cases we see considerably more market volatility in response to the recent end of periods of Quantitative Easing than we saw in either of the post interest rate hike periods in 1994 or 2004.
All of this is basically a round-about way of saying that I am not sure what sort of predictive power the 1994 and 2004 rate hike episodes offer for the market today—those periods seem better suited to offer analysis for what might happen when the Fed has completely ended QE and is considering actual rate hikes. In the interim, my prediction is that the more recent tapering of QE1 and QE2 offer better guidance for what to expect from the market as QE3 draws down and ends—an initial decline in the market, followed by a recovery that will be dictated by economic data, forward guidance from the Fed, and timelines related to when the Fed plans to lift the economy off of the zero-lower-bound.