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Investors Have Forgotten that Central Bankers can Raise Rates Quickly

14 Aug 2018 - Central Banks & Bullion

The end of May 2014 marks an important milestone in the practice of central banking.  It has been ten years since the most influential central bank – the US Federal Reserve – last began a tightening cycle. 

That is ten years since the start of the last tightening cycle and about eight years since the Federal Reserve last raised interest rates!

The incredible length of time from the last time the US central bank raised rates makes one wonder – have investors forgotten that central bankers can raise rates quickly?

Here is the likely reason investors have forgotten about agile central bankers. 

The figure shows the past 11 Federal Reserve tightening cycles. 

(As a note of explanation, the y-axis is the change in the effective federal funds rate from the beginning of the respective tightening cycle.  The x-axis represents the number of days the given tightening cycle has lasted.  The lines represent a given tightening cycle, with the label for each line representing the month and year in which the tightening cycle started.)

As an example, consider May 2004.  Mr. Greenspan’s Federal Reserve began raising interest rates in May 2004, eventually raising the Fed’s target short-term interest rate from 1 percent to 5.25 percent.  The cycle lasted almost 1,200 days (about three and a quarter years). 

As is readily apparent, the Fed was incredibly slow to respond to economic conditions, taking almost 800 days to increase the target rate from 1 percent to 5 percent and then doing nothing for the next 400 days.

The story of less agile US central bank is quite transparent over the past 20 years, with a gradual shift downward in the strength of the given cycle.

Given the evidence that the US central bank – with other central banks generally following suit – has become less agile, it comes as no surprise that investors have forgotten that central bankers could increase rate quickly, by say 200 basis points in a given decision rather than the more commonly presumed 25 basis points at a time.

Interestingly, even members of the Federal Reserve are “cautious” in their expectations.  At the high end, some Federal Reserve members have the target interest rate at 2 percent in 2 years.  Could there be a weaker tightening cycle?

Of course, central bankers have not always been so cautious.  In the early 80s, Mr. Volker’s Fed raised rates very quickly to counter hyperinflation, costing President Carter his job (anyone think central bankers are independent anymore?). 

In any event, overall, investors appear to have forgotten that central bankers could be agile and increase rates quickly.  Will they do it?  Probably not given the increasingly politicized technocratic institutions.  Interestingly, this paints a positive picture for precious metals, in that weak central banks are much more likely to be behind the curve in addressing inflationary pressures.

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