Editorial

Fed lessons for Janet Yellen

Jan 5, 2014 @ 12:01 am

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The Federal Reserve System celebrated its 100th anniversary Dec. 23, and as it begins its second century, it will soon have a new chairman, Janet Yellen. The question for investors as the new era begins is: Has she absorbed the lessons of the Fed's modestly checkered past?

In its 100 years of existence, the Fed has had some notable successes and a few really troubling failures. The failures often resulted from a misreading of the lessons of its successes, and a touch of hubris.

For example, the Fed is supposed to promote price stability, yet the Consumer Price Index has increased by 3.2% per year during the central-bank era, compared with -0.5% per year in the 1800-1912 period, according to research by analysts at Leuthold Weeden Capital Management.

The Fed was established in 1913 after the financial panic of 1907, which was ended by the intervention of a private conglomerate headed by J. P. Morgan.

The conglomerate, in effect, became the lender of last resort to the nation's banks, filling the role that the Fed holds today. The Fed was established in the belief that depositors would no longer panic and withdraw their uninsured deposits at the first signs of financial difficulty if they knew that their bank could borrow from the central bank.

As a result, bank runs declined in the years following the establishment of the Fed. In addition, the Fed reduced seasonal interest rate volatility by increasing loans to member banks when loan demand was high and cutting back when it was low.

GREAT DEPRESSION

This strategy backfired in the late 1920s and contributed to the depth of the Great Depression. The Fed noted the slack demand for loans as the economy weakened, but assumed no need to lend more money to the nation's banks.

This fatal error caused the money supply to contract, turning a recession into a depression.

Officials at the Fed learned from this experience. The result was a long period of relative stability during the 1940s and especially the 1950s, when the Fed stepped in judiciously to smooth economic cycles.

Unfortunately, in the 1960s and 1970s, the Fed stepped in too strongly to offset what it saw as weakness, and the result was the stagflation of the late 1970s-early 1980s. That was halted by Chairman Paul Volcker, who ratcheted up rates and triggered a recession in 1981-82 that was followed by a strong recovery and steady growth.

Once again, the Fed seemed to learn the appropriate lesson, and Chairman Alan Greenspan and his central-bank colleagues seemed to get everything right between 1987 and 2007, successfully handling the 1987 stock market crash and the recession brought on by the technology bubble and exacerbated by the Sept. 11, 2001, terrorist attacks.

OFFSETS

Unfortunately, that success caused the Fed to miss the buildup of risk in the economy, and the fact that the flood of money into the economy from China and elsewhere was offsetting its mild efforts at tightening from 2005 on. The Fed seemed to think it had the economy all figured out — a touch of hubris.

The five-year effort to power the economy out of the Great Recession should have demonstrated to the Fed that its powers to manage the economy are limited, as the recovery has been slow despite its Herculean efforts.

Investors and their financial advisers should hope that Ms. Yellen and her colleagues will draw the correct lessons from this history. Perhaps the most important lesson is contained in the old saying: “In all things, moderation.”

If Ms. Yellen and her colleagues put all the lessons together in the right order and apply them appropriately, the economy will recover soundly and investors will be rewarded.

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