Exit Is Easy, Revisited

by: Scott Sumner

Gavyn Davies has an overly pessimistic column in the Financial Times. Here's the intro and conclusion:

On Wednesday, the chairman of the Federal Reserve announced that the greatest experiment in the history of central banking might be nearing its end.

The exit from quantitative easing was always going to be long and arduous. There is no historical playbook for the central banks to follow. Like a fighter pilot who has experienced combat only in a flight simulator, the real thing might be very different. The central bankers are confident that they have the technical tools to finish the job but, as Bernanke admits, it will be like landing that plane on an aircraft carrier, and possibly in stormy seas.

This is all wrong; it's easy to exit monetary stimulus. And indeed Davies shows this, even as he thinks he is showing the exact opposite:

The last big unwind -- a much smaller one -- started almost exactly a decade ago. On June 25, 2003, the Federal Open Market Committee met amid expectations of a cut in the interest rate from 1.25% to 0.75%.

Alan Greenspan was chief wizard at the Fed that day. Bernanke, more radical than he is now, was there, but mostly stayed silent. The committee was fully aware of the dangers ahead when it decided to cut the federal funds rate by only 0.25 percentage points. The market concluded that the Fed was preparing to tighten policy sooner than expected, and sharply adjusted expectations for where it thought rates would be in the years ahead. The same thing happened this week.

Yes, and the economy was fine. Davies continues:

The previous big Fed exit, announced on Feb. 4, 1994, was even more dramatic. It was a day that triggered such turbulence that it is etched in the memory of all bond traders. Working as a Goldman Sachs economist, I was on the bond trading floor when the Fed released an innocuous-sounding statement. The FOMC had decided 'to increase slightly the degree of pressure on reserve positions ... which is expected to be associated with a small increase in short-term money-market interest rates.' Pardon? After a few moments, there was an explosion of noise as realisation set in.

The market was unprepared for the Fed change, Investors were over-leveraged and knee-deep in Mexican debt and mortgages. Equities emerged relatively unscathed. But before the bloodbath ended that November, the survival of the U.S. investment banks was at stake.

The tip-off is the "equities emerged relatively unscathed" remark. I've been around for 58 years and can't recall a more boring and uneventful year than 1994. That means Fed policy was working. Boring is good! Yes, there was some turmoil in the bond market, but bond markets don't matter -- what matters is NGDP. And that was fine. The sooner we remove finance from monetary economics the better. All it does is lead to fuzzy thinking.

Davies also discusses a botched exit, the Japanese monetary policy tightening of 2006. But that wasn't because exit is hard, but rather because they tightened policy after 10 years of steady deflation. The technical term for that policy approach is insane. Why would you tighten monetary policy when prices have been falling for 10 years, and the bond market shows no signs of inflation going forward?

And why would the Fed tighten monetary policy with 7.6% unemployment, 1.05% core PCE inflation (0.7% headline), and the TIPS markets showing 1.7% inflation over the next five years? That's also insane. And let's not even talk about the ECB in 2011.