The Fed Put Is Back

This is an excerpt from the March 25, 2024 Yardeni Research Morning Briefing.

Monetary Policy I: Post-Modern Monetary Theory. Melissa and I received quite a few favorable reader comments on last Monday’s Morning Briefing discussing our “Post-Modern Monetary Theory” (P-MMT). Many of the comments included thought-provoking queries about our P-MMT, which I address below. In addition, the Financial Times is running my summary of our theory in an op-ed titled “The Fed should resist messing with success.”

The basic concept of P-MMT is that recessions are caused by a process that leads to such economic downturns. As an economic expansion proceeds, inflationary excesses build up in goods and services markets as well as in asset markets along the way. Typically, as confidence builds in the longevity of the expansion, borrowers borrow more to purchase goods and services as well as assets. As such purchases become more leveraged, they expose both the borrowers and lenders to more risk.

The buildup of such inflationary and speculative excesses forces the Fed to tighten monetary policy. Interest rates rise, but along the way short-term rates rise faster than long-term rates. This leads to an inversion of the yield curve signaling that bond investors anticipate that if the Fed continues to raise short-term interest rates, something will break in the financial system. In the past, they’ve often been correct: A financial crisis triggered by continued monetary tightening did ensue (Fig. 1 and Fig. 2 ). Such crises often resulted from the collapse of financial institutions that had lent too much to borrowers who no longer could service their debts when monetary conditions became tighter than either the creditors or debtors had anticipated.

In the past, the financial crises quickly turned into economy-wide credit crunches. So even borrowers with good credit ratings were unable to borrow. The Fed would respond by lowering interest rates, which it often did before the recessions occurred, i.e., when the financial crises first hit. The federal funds rate typically peaked at the point when the financial crises started. The yield curve would “disinvert” before the recessions officially started.

This stylized rendition of the business cycle illustrates that inverted yield curves don’t cause recessions, as commonly thought. Inverted yield curves anticipate recessions and often correctly—though clearly not over the past two years, so far. The tightening of monetary policy sets the stage for recessions by bursting speculative bubbles inflated by too much debt—again with the clear exception of the past two years. The Fed often has been compelled by persistent inflation to cause a recession by tightening monetary policy to bring inflation down.

According to our P-MMT, there are no “long and variable lags” between the tightening of monetary policy and recessions. Instead, recessions occur rapidly after tighter monetary policy triggers a financial crisis that isn’t contained by the Fed and that therefore turns into an economy-wide credit crunch.

Again, the past two years have been exceptional. Inflation soared during 2022 through the summer of 2023 and then moderated significantly through early 2024. This time, as in the past, monetary policy was tightened to lower inflation, which is what happened—but without causing a recession, so far.

Why has the latest experience differed from the business, credit, and monetary cycles of the past? Here is what we wrote about that last week:

“During the Great Financial Crisis, the Fed learned how to rapidly establish emergency liquidity facilities. That’s what the Fed did in response to the pandemic lockdowns. As a result, the pandemic recession lasted only two months. The Fed did it again last year when a banking crisis developed during March; that time, there was no recession at all. … If the Fed can continue to manage financial crises and avert economy-wide credit crunches, then the risk of a recession is reduced during monetary tightening cycles.”

If the Fed can contain financial crises with emergency liquidity facilities (ELFs), then the crises won’t turn into economy-wide credit crunches that bring on recessions.

Monetary Policy II: Emergency Liquidity Facilities. A few of our accounts wondered whether the Fed’s ability to rapidly respond to financial crises by creating ELFs means that the “Fed Put” is back. The Fed averted recessions during the financial crises of 1987 and 1998 by providing and targeting ample liquidity where it was needed. Here is what I wrote in my book Predicting the Markets (2018):

(1) Black Friday (1987). “Two months after Greenspan’s confirmation, the stock market crashed on Black Monday [October 19, 1987]. The Fed immediately issued a statement affirming its readiness to serve as a source of liquidity to support the economic and financial system. The federal funds rate was lowered from 7.61% on October 19 to 5.69% on November 4. Gerald Corrigan, the president of the New York Fed, pressured the major New York banks to double their normal lending to securities firms, enabling brokers to meet cash calls. Greenspan later told the Senate Banking Committee that the Fed’s strategy during Black Monday was “aimed at shrinking irrational reactions in the financial system to an irreducible minimum.” That was the beginning of the Greenspan Put and affirmed my view that the financial crisis could mean buying opportunities in the stock market.”

(2) LTCM (1998). “A few months later, during September 1998, Long-Term Capital Management (LTCM) blew up. The huge hedge fund had accumulated on a notional basis more than $1 trillion in OTC derivatives and $125 billion in securities on $4.8 billion of capital. The Federal Reserve Bank of New York orchestrated a bailout of the firm by its 14 OTC dealers, who had been clueless about LTCM’s enormous bets.”

(3) Whac-A-Mole. The Fed’s Whac-A-Mole approach to liquidity crises was certainly tested during the Great Financial Crisis. It didn’t avert a credit crunch and a recession back then. It did so during the Great Virus Crisis (as evidenced by the lockdown recession lasting only two months) and during last year’s banking crisis (Fig. 3 ).

The Fed’s rapid-response, Whac-A-Mole approach to managing financial crises may very well reduce the likelihood of recessions and their severity if they occur. Needless to say, the success of this approach depends on whether inflationary pressures that occur during business-cycle expansions are transitory or so persistent that they require a Fed-induced recession to subdue. No theory is necessary to explain why recessions typically reduce inflation very effectively, with the obvious exception of the Great Inflation of the 1970s (Fig. 4 ).

A recession failed to subdue the Great Inflation of the 1970s because inflation then was exacerbated by numerous related and unrelated inflationary policy, geopolitical, and random shocks. Most importantly, two energy crises caused oil prices to soar twice during the decade and resulted in twin inflationary peaks in the CPI (Fig. 5 ). These shocks triggered a wage-price-rent spiral during the decade that required the Fed to induce a recession with unprecedented monetary tightening during 1979 (Fig. 6 and Fig. 7 ). Back then, there were more and bigger moles that needed to be whacked with a bigger monetary mallet.

Now let’s turn to the impact of the new and improved Fed Put on today’s financial markets, focusing on the potential for a significant asset bubble that could cause a recession if it bursts.

Monetary Policy III: Asset Inflation Is Back. The financial markets are showing signs of exuberance. Some of it undoubtedly is fueled by the Fed’s new, improved Fed Put. The question is whether it is the rational or irrational variety of exuberance. The fact that we are asking rather than answering the question suggests that the current bull market in stocks might be comparable to where it was on December 5, 1996, when then-Fed Chair Alan Greenspan famously asked : “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions.”

What does P-MMT predict might happen over the rest of the year? The theory is that recessions are caused by credit crunches that are triggered by financial crises attributable to the tightening of monetary policy. Fed officials seem to believe that higher real interest rates can cause recessions too. So they’ve been signaling their intention to lower the federal funds rate three times over the rest of this year if inflation continues to moderate. This may reduce the risk of a recession (which we think is minimal even if the Fed doesn’t ease), but it also easily could cause investors to become even more exuberant, and irrationally so, leading to the “unduly escalated asset values, which then become subject to unexpected and prolonged contractions” that Greenspan warned about.

Try our research service . See our Predicting the Markets book series on?Dr. Ed's Amazon Author Page . Please see our hedge clause .