From Antonio Fatas and Ilian Mihov on the Global Economy:
Here is a follow up to my previous post about what to expect when
Quantitative Easing is reversed. The point I made earlier is that the
more likely scenario for tightening of monetary policy is that this will
happen when growth gets stronger. Krugman makes the same point in his latest post.
But I can also see plenty of articles talking a much more pessimistic
view and describing all the bad things that will happen when central
banks change their current monetary policy stance from expansionary to
neutral, including a large downward adjustment to stock markets. I am
surprised that there are very few historical references in those
articles, so let me produce two to refresh our historical memory.
What has happened to the stock market in previous cycles after the
central bank decided to abandon its policy of low interest rates and
start raising those rates? I will use US data and I will focus on the
last two episodes:
1. After the 1990 recession, interest rates remain low until February
1994 when the Federal Reserve started increasing rates from a level of
3% to 6.6% in May of 1995.
2. After the 2001 recession, interest rates were lowered to 1% and then
started to increase in June 2004 from that level to 5.25% in June 2006.
The image below plots the evolution of the stock market in the months
that followed both episodes. The Dow Jones Index is rebased to be equal
to 100 the month when interest rates started going up -- I also provide
the previous 12 months to get a perspective on what happened during the
previous year. [Note: I stop the series
when I see interest rates declining again as growth slows down in 1997
or as we enter the recession of 2007.]
In both cases we see a similar patter. Initially the stock market moves
sideways. During the first year there are gains of about 1%. But the
years that follow, and once the increases in interest rates have stopped
we see large increases in the index -- interest rates stopped
increasing in the first episode 12 months after they started going up;
in the second episode it happened about 24 months later. This is more or
less when the stock market starts its climb....
MORE
