Ever since the Fed launched its unprecedented, unsterilized debt monetization rampage known as quantitative easing, coupled with seven years zero interest rates, there has been much confusion about how the Fed will achieve two gargantuan tasks: i) hike rates, and ii) reduce the amount of holdings on its balance sheet. The quandary, according to conventional wisdom, is magnified because something like this “has never been done before.”
Conventional wisdom is wrong: something like this has been done before; the reason why nobody wants to talk about it is because it ended in epic disaster.
The chart below shows the Fed’s balance sheet expressed as a % of GDP: it has grown from its long-term “normal” 5% to just over 25%.
Never before has this happened, right? Wrong.
As the following chart below shows, the Fed’s response to the first (not to be confused with the current) great depression was, drumroll, identical.
Whereas the Fed’s balance sheet expressed as a % of GDP was humming along nicely largely at just over 5% in the period ever since the Fed was created in 1913, things got promptly out of control when the Great Depression hit in 1929. At that point the Fed’s balance sheet grew from 5% to just shy of 25% at its peak. Maybe there is a reason why some call the current period the second great depression…
More to the point, last night we showed that the first Great Depression period is comparable to the current time period not only in being a mirror image of the Fed’s balance sheet, but also of interest rates, which by necessity had to be virtually zero in a time when the Fed was monetizing assets to stimulate aggregate demand. And so they were… until 1937, when the Fed hiked rates.
As we showed yesterday, what happened next was that a little over a year after the Fed hiked rates for the first time, the Dow Jones tumbled, plunged by 50% in March 1938 (the S&P500 in its current form would not appear for another 20 years).
But that was the topic of last night’s post. What we want to emphasize here is what happened after. Because as the market crashed and the economy collapsed yet again in the last such acute episode of the Great Depression, something far more historic than a simple market collapse took place.
In other words, from the first rate hike by a Fed whose balance sheet as a % of GDP was nearly identical to the current one, to the start of World War II: less than three years.
We truly hope this time its different, although judging by today’s dramatic return of the nuclear arms race and the countless war zones across the middle east and Africa, slowly all the increasingly militarized geopolitical events are falling into place.