Fed Funds, CPI, and the Stairway to Where?

We look at fed funds vs. CPI from 1990 to 2007 as a “normal” market sampler of tightening and easing cycles.

Summary

As we look back across the main events from the 1990 recession to the 2007 business cycle, the most telling experience of what a “normal” set of markets looks like still shows fed funds running ahead of CPI. There were moments where the Fed had to play catch-up (2003-2006) but that was a function of protracted excessive easing into 2004.  That is not a good harbinger for what the market is looking at today. Fed funds needs to double in order to line up close to core CPI with headline CPI even more distant. We already looked at the fed funds vs. CPI differentials history from 1972 to 2022, and it is a troubling contrast (See Fed Funds-CPI Differentials: Reversion Time?).  

History shows that the Stairway to Heaven in monetary accommodation can call an express elevator to hell just as easily. That is especially true if the result is excess systemic leverage, too much financial product experimentation, and an embrace of a caveat emptor mentality. If you wrap that in unbridled counterparty exposure, then bank interconnectedness risk lurks.  That will need to be on the macro checklist for regulators if more of Europe goes off the rails and China-US geopolitics or trade flows head south. As we look back, the 1990s brought what can be seen as the creative destruction of TMT evolution that likely will be treated kindly in history. In contrast, the post-TMT cycle brought way too much “creative” and the potential for systemic “destruction.” As we roll on in an inflationary period, the path ahead is very uncertain.

The chart looks at fed funds upper target vs. CPI from the recession start of 1990 on through the TMT bubble years and into the housing and structured credit wave that by 2007 set the table for the systemic crisis of 2008. These two cycles above are very distinct in the economic backdrops and what drove the growth. The common feature is both cycles kicked off with extended low fed funds rate and steep curves that lasted a few years into overtime.

The chart drives home the theme that fed funds generally ran higher than CPI during these extraordinary periods. The chart also offers a reminder of how fast the Fed operates once it starts moving. The chart shows the many steps and quick step changes in the Fed’s upper range target for fed funds. The flip side is that the Fed was slow to reload and aim for higher rates. That created a lot of room for market misbehavior.

Key Takeaways

Fed funds > CPI : The low fed funds today vs. CPI gets a bad review from the 1990s Fed approach. The FF-CPI path is more about common sense patterns of the past than econometric gymnastics and monetary policy smoke-filled rooms. Was the fed wrong then even when they so routinely demonstrated their willingness to go easy in tough times such as 1991 and 2001?  The above chart continues the theme of framing fed funds vs. CPI levels. This chart looks across a volatile stretch of time that starts with the post-1980s business cycle (note: recession started in July 1990) and ends with the 2007 credit cycle peaking just ahead of the Dec 2007 start of the recession (note: Dec 2007 was not officially designated as the peak until the credit crisis was well underway in Dec 2008). 

These years from 1990 to 2007 at least were more grounded in economic fundamentals and the usual capital markets excess rather than a bank system crisis (2008) or a deadly global pandemic (2020). These 1990s/early 2000s years were also lower inflation years in historical context. The 1990s surprised the Fed/FOMC more than a few times with the economy’s ability to handle tight labor markets and higher capacity utilization without CPI (or PCE) getting worrisome.  

What is a normal cycle in the new capital markets era?: The trick in making a case for what is a logical pattern for such fed funds vs. CPI relationships is each cycle has been very different in the “modern capital markets era.” I would date that modern era’s beginnings in the 1980s with the rise of mutual funds and the rapid disintermediation of the banks and private placement departments of the major insurance companies (I started in the private placement department of Prudential – at the time the largest corporate bond investor in the nation). That period also gave rise to the US High Yield Market as the private equity players and Drexel saw a way to keep the equity upside for the home team and lay off the capital structure intensity. That was also during the Glass Stegall years when banks were not in bonds.

The 1990-2007 stretch is the best petri dish for normalcy – strange as that may sound: This might be a longwinded way to say the 1990-2007 period was as close as you might get to being normal. Those cycles reflect the arrival of the commercial banks into the bond underwriting business and the brokers into loans. The credit crisis disrupted the normal capital markets functioning in 2008 as we covered in earlier commentaries the past two weeks. The same is true for COVID. That is why we keep going back to this period of almost two decades for a sense of patterns. The 1990s saw breakneck growth in credit markets in the US and in the Euro corporate markets starting in 1999. For now, we still use the above period as the best stretch of time on what a business cycle or credit cycle looks like when not operating in an extended multi-year ZIRP-based bailout with a lot of Quantitative Easing on the Fed books.

Smaller lineup by number of players in a giant market: The fact is that the market is also bigger than ever now (by a lot), and the market makers are fewer. There was a lot of changes since the 1980s Glass Steagall years with US brokers gone and more banks piling in. That is enough to make the post-1980s generation very different in the regulatory overlay. Since the year 2008 happened, most of the big boys now are banks with only two of the original bulge bracket leaders still standing (as banks) with Goldman and Morgan Stanley.  The eyes of the Fed (and FDIC and OCC) are more closely tuned than ever to the major banks, and that will necessarily influence Fed policy just as it did in 1991-1992 and again with the credit crisis since 4Q08. The 2001-2004 manic Fed easing is much harder to explain.  The banks were in good shape relative to 1991-1992.

For a summary checklist for “new guys” in the business, the “then vs. now” list is stunning to those of us that were in the ranks across these periods. Merrill became BofA after the Lehman collapse weekend of 2008.  BofA in its form came via a NationsBank merger (1998). Bear is now JP Morgan on the Fed engineered bailout in March 2008. JP Morgan is the creation of a laundry list of banks (via a list in no special order of Bank One, Chase, Chemical, Manufacturers Hanover, etc.). Lehman was scattered to the winds in pieces (Barclays, Nomura) and some ashes, Salomon is Citi, First Boston is Credit Suisse, Kidder Peabody is a Swiss bank trivial pursuit question along with PaineWebber. Drexel filed Chapter 11 in 1990 and DLJ was the winner in the personnel wave on DLJs way into CSFB. 

Shifting cycles and changes in fundamentals call for action: Today’s high level market risk is much more dire than the modest inflation moves of the 1990s and early 2000s and thus the need for higher rates is also greater.  The use of these cycles as an example in the above chart is more to draw a distinction from the very mild fed funds rate today relative to inflation. The frame of reference makes it harder to be complacent about where this all might head. The generic priority of financial stability gives the Fed a lot of room to maneuver whether it be to watch out for the banks while it also complies with the much-discussed dual mandate of full employment and price stability.

We don’t see banks in trouble even if we see a very tenuous state of affairs in global markets with such widespread consumer stress and economic pressures from global inflation. The volatility in the UK is a reminder that macro volatility can break out with a vengeance and roil leveraged exposures. Then the boogeyman of counterparty risk creates fears of the unknown whether that be “ticking hedge funds” or the risk of massive losses buried in financing operations. We have seen concentrated positions in hedge funds or loans against an asset lead to margin calls that then becomes a counterparty default and giant loss for some bank.  One man’s bad hedge position is another man’s credit risk.

1991-1992 as closet bank bailouts or intensive care: Among the more notable highlights in the chart were how low the Fed kept fed funds in 1991 and 1992 despite the rally in the expansion getting underway after March 1991 and the solid economic growth seen in 1992 (+2.5% GDP growth 1992). The effort to prolong accommodation in the early 1990s arguably was part of a closet bank system “mini-bailout.” The underlying reason for such protracted Fed support in my view was the messy backdrop in the commercial banking sector (e.g., Citibank was in deep trouble at the time) with commercial real estate spiraling into a crisis across numerous regions. After the oil patch led off regional meltdowns in the 1980s, the market saw real estate stress and overbuilding in a range of other regional markets from Boston to the West Coast. The thrift crisis was also still a major headache in California as Washington Mutual (a later casualty of the credit crisis) was hoovering in branches across the 1990s as part of a bank and thrift industry restructuring underway. Running alongside was Countrywide Credit that found its launching pad after the early 1990s jitters.  The Fed accommodation may have headed off some major problems, but it also created opportunities for the well positioned to execute on M&A and expansion. Countrywide ended up with a de facto BofA merger/bailout that started in the summer of 2007.  

Late TMT cycle decisions make for tough Monday morning quarterbacking: The immediate reaction of the Fed to a brief upswing in inflation in the late 1990s (notably 1999-2000) saw rapid tightening and that did not do wonders for the bursting TMT bubble. Then the Fed reversed course in dramatic fashion in 2001 with a lot of rapid incremental steps in lowering Fed funds targets even with the expansion going on since March 2001. The 2001 tally was around 11 cuts with 8 of 11 at 50 bps and most of them before 9-11. The inflation line implies the policy was all about concerns for the employment part of the dual mandate, but the expansion was well underway. I imagine the Fed would like a do-over on that one even if they don’t admit it.

The post-TMT cycle after 2001 could be named the “housing bubble, subprime mortgages, structured credit, and counterparty binge” cycle, but that label lacks rhythm. The “#&@!show Cycle” is not printable. The year 2004 started at a 1.0% fed funds rate over 2 years into an expansion. That was when fed funds lagged inflation. They market paid a price for that. The lookback exercises since then tend to see some blame games targeting Greenspan for sowing the seeds of the housing crisis and making it easy (and profitable) to drive high volumes in leveraged finance (record LBOs) and structured credit.

So here the market is today with fed funds around 5 points below CPI. That can’t be a good thing.