The History of FED Pivots

Introduction

Since its inception over a century ago, the United States Federal Reserve has been instrumental in shaping the U.S. economy, often undergoing significant policy shifts, or "pivots," to navigate the changing economic environment. These transitions, marked by the decisions and actions of the Fed, have substantially impacted the trajectory of the U.S. economy.

The past 20 years have seen the Fed maintain a generally low-interest rate environment. Real yields, which are yields less inflation expectations, have been on a downward trend for 40 years. The predictability of these low rates often encourages speculation, which can, in turn, lead to riskier investment behavior. As seen in the aftermath of the 2020-2021 policy response to the pandemic, both conservative and aggressive financial entities took outsized risks. Accepting negative real returns, after all, is not conducive to profit.

In this article, we will explore the significant shifts in the monetary policy of the United States Federal Reserve over the past century, and the resulting impacts on the U.S. economy. We will delve into the Fed's strategic decisions in response to major economic events such as the Great Depression, post-World War II recovery, the 1970s stagflation, the 2008 financial crisis, and the COVID-19 pandemic. We'll also evaluate the influence of these policies on the overall economic climate, including periods of low-interest rates and their impact on investment behavior. Moreover, we will analyze historical trends associated with the Federal Reserve's rate cuts and their correlation with bear markets. Join us as we dissect the pivotal role of the Fed in shaping the economic trajectory of the U.S., and what lessons we can glean from these experiences.

The History

During the devastating Great Depression of the 1930s, the Federal Reserve initially attempted to stabilize the dollar by raising interest rates, a move which inadvertently plunged the economy deeper into crisis. The Fed soon corrected course, lowering interest rates and expanding its balance sheet, fueling the slow yet steady recovery, although it couldn't reverse the calamitous damage inflicted in the early years.

In the aftermath of World War II, the Federal Reserve adopted a strategy of low interest rates to manage national debt and bolster post-war recovery. However, growing inflationary pressures led to a pivotal policy change. The Treasury-Federal Reserve Accord of 1951 marked this transition, granting the Fed greater autonomy to raise interest rates and address mounting inflation.

The 1970s introduced a unique challenge: stagflation, characterized by stagnant economic growth coupled with high inflation. In response, the Federal Reserve, under the firm hand of Chairman Paul Volcker, chose to dramatically increase interest rates, triggering a recession but successfully reining in inflation. This significant policy shift underlined the Fed's dedication to maintaining price stability.

The financial crisis of 2008 sparked yet another dramatic pivot. In an unprecedented maneuver, the Federal Reserve slashed interest rates to near-zero levels and initiated a program known as Quantitative Easing (QE), involving the large-scale purchase of government and mortgage-backed securities. Aimed at lowering long-term interest rates, increasing the money supply, and invigorating economic activity, this strategy diverged sharply from conventional monetary policy tools and established a new precedent for central bank crisis response.

Following the 2008 crisis, the Fed began a measured process of interest rate normalization in 2015 as the U.S. economy started to show signs of recovery. The gradual increase in interest rates marked a strategic pivot away from the ultra-low interest rates characteristic of the post-recession period.

The onset of the global COVID-19 pandemic in 2020 spurred another economic crisis, prompting the Federal Reserve to return to a policy of low interest rates and QE. In August 2020, the Fed made a significant shift in its inflation targeting strategy, adopting "average inflation targeting," which tolerates periods of higher inflation to compensate for periods of low inflation.

Notably, historical data indicates a bearish trend associated with significant Federal Reserve rate cuts. Since 1970, there have been nine instances where the Fed substantially reduced the Federal Funds rate, each time causing substantial stock market declines or 'drawdowns,' averaging 27.25%. The more recent episodes have seen even larger-than-average drawdowns.

Final Thoughts

Over the past two decades, the predictability of low interest rates maintained by the Fed has often spurred speculation and encouraged riskier investment behavior. As witnessed during the 2020-2021 policy response to the pandemic, both conservative and aggressive financial entities took outsized risks. After all, accepting negative real returns does not bode well for profitability.

Each decade presents its own set of challenges. The 1980s were characterized by a battle against the "Great Inflation," with a surge in inflation to a record 14.6 percent in 1980. The Fed intentionally induced a recession to combat this, hiking the fed funds rate to a staggering 19-20 percent. By the 1990s, under Greenspan, the Fed adopted a policy of "insurance" cuts, reducing interest rates as a preventive measure against potential downturns. With the turn of the millennium came a series of crises, including the burst of the tech bubble in the early 2000s and the Great Recession in 2008, both of which led the Fed to drastically lower interest rates and innovate with unconventional tools like Quantitative Easing. Then, the 2020s were ushered in by the unprecedented COVID-19 pandemic, pushing the Fed to reenact a policy of low interest rates and Quantitative Easing, as well as adopting a novel average inflation targeting strategy. These actions are a testament to the Fed's adaptability in responding to diverse and complex economic challenges. As we continue to navigate the unpredictable ebb and flow of the economy, the lessons drawn from these past experiences underscore the importance of prudent monetary policy. As history has shown, the Fed's role in steering the economy is paramount, and its decisions will remain a critical factor in shaping the economic future of the United States.