Thursday, June 10, 2010

The Real Problem With An Early Fed Tightening Move

The Kansas City Fed President, Thomas Hoenig, has been an increasingly vocal proponent of the view that that the Fed should no longer offer financial markets the promise of zero short-term rates for an "extended period" of time- having dissented in each FOMC meeting since the beginning of the year over the use of such language in the official statement. In recent days, and on two separate occasions, he has upped the ante by arguing that the Fed should raise the fed funds rate to 1% by the end of summer. (

Mr. Hoenig's rationale is a fairly straightforward one: short-term rates are at unustainably low levels, setting the stage for inflationary complications over the long run, and the economic recovery has already gained sufficient traction to withstand a series of modest steps that would signal the beginning of the normalization process for rates. Furthermore, according to that view, monetary policy is meant to be anticipatory and leaving rates at zero for too long would risk planting the seeds for the next bubble that could destabilize the financial system again; therefore, it needs to act soon before any such clouds appear on the radar screen.

A limited number of other Fed officials also appear to be showing signs of uneasiness recently about the possibility that the Fed may be creating some risks by delaying the beginning of the exit strategy; Philadelphia Fed President Plosser and St. Louis Fed President Bullard have made some "soft" comments along those lines in the last few weeks.

On the face of it, it is hard to disagree with Mr. Hoenig's argument on this issue. The U.S. economic recovery is moving forward in the context of a broader, albeit uneven, turnaround in the global economy and the financial system. Although the latter is still confronted with seemingly never-ending challenges (the latest one being the sovereign debt market turmoil), it has admittedly come a long way since the heady days of 18 months or so ago. Against such a backdrop, how damaging a relatively modest increase of 75 to 100 basis points in the fed funds rate- or beginning the unwinding of the Fed's massive portfolio- can be to the economy or the financial system?

This view, though, does suffer from a serious flaw in that it vastly underestimates the potentially disproportionate negative reaction that financial markets will show to concrete actions signaling that the interest rate cycle is turning. The Fed's raising of the fed funds target, as well as the interest it pays on bank reserves, by as much as 100 basis points in a series of quick moves over the next couple of months (the latest time frame proposed by the Kansas City Fed President) is likely to lead to a major selloff in the bond market, as participants, in typical fashion, will front run the prospect of further tightening by the Fed. After all, the funds rate would still be at an extremely low 1% and, by most people's standards, the concept of normalization of short-term rates would envision a road toward a funds target in the 3% to 4% range.

The bulk of such a selloff in response to the Fed's first shot across the bow would be heavily skewed toward the front end of the market, causing a severe flattening of the yield curve, which, in turn, would undercut one of the key factors that have contributed to the healing and return to relative profitability of the banking system in the last several quarters. In view of the recent doubling of the 3-month Libor rate to over 50 basis points- a direct reflection of the anxiety percolating in the European banking system due to the sovereign debt situation- an abrupt further increase in short-term rates that would be set off by any Fed tightening can prove dangerously destabilizing for the global financial system in the current setting.

Inflation in the U.S. and eurozone remains at extremely low levels and, given the unimpressive forward momentum of the economic recovery in both regions, it is unlikely to show any upturn over the next 12 months or so. With regulatory financial reform in the offing, both in the U.S. and Europe, and the threat of a default by some countries (the debt of which is largely held by European banks) lurking in the background, the global banking system is finding itself again at a key juncture.

None of this suggests that the Fed should remain sidelined out of fear of potentially disturbing the fledgling economic recovery and delicate balance of the banking system. Short-term rates are indeed unsustainably low and the gradual unwinding of the Fed's balance sheet may indeed start taking place later this year, before any other overt tightening policy action is announced.

But it is imperative to recognize that the view Mr. Hoenig has been openly advocating has a major hidden risk, as it is not about just a series of modest steps that would still leave the funds target at a historically very low level- therefore unlikely to be very consequential to the broader environment. A series of modest such rate hikes by the Fed will translate into a potentially massive back up in yields that would far exceed the actual Fed action. And for that to be absorbed relatively smoothly (that is, with only a reasonable amount of noise), without throwing everything up in the air and creating renewed sources of anxiety and turmoil, the Fed needs to be highly confident that the time is ripe for such action.

The inevitable change in the FOMC's language from the current "extended period" wording will be the first test of the markets' ability to handle stress over the next few months, on the account of a perceived risk of real tightening down the road. But, arguing that the overall economic and financial environment is ready at this point to accept the blow of actual Fed tightening over the next couple of months is a proposition somewhat disconnected from the realities on the ground as to how markets function.

Anthony Karydakis

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