Fed­eral Re­serve, show some spine

The Pak Banker - - OPINION - Wil­liam D. Co­han

THE fi­nan­cial mar­kets and the Fed­eral Re­serve Board have been play­ing out a tragi­com­edy in three acts. Here's how it works: Ini­tially, a flurry of news sto­ries ap­pear about how, a few months hence, the Fed in­tends to raise short-term in­ter­est rates for the first time in years. Sec­ond, the pre­dictable mar­ket swoon, as Wall Street traders pon­der the fact that the mor­phine drip of free money that they have been en­joy­ing since the af­ter­math of the 2008 fi­nan­cial cri­sis might be pulled out of their arms. Fi­nally, the Fed backs away from its much-over­due pol­icy change, caus­ing traders to re­joice and the ar­ti­fi­cially stim­u­lated bull mar­ket in both stocks and bonds to con­tinue. The cur­tain comes down, and the au­di­ence roars its ap­proval.

A sim­i­lar drama oc­curred in the spring of 2013, dur­ing what has been called the Ta­per Tantrum. And now it's hap­pen­ing again.

Some back­ground: At the end of 2008, the Fed dropped its bench­mark short-term in­ter­est rate to around zero. It also be­gan a pro­gram with the Or­wellian name of quan­ti­ta­tive eas­ing - buy­ing huge sums of bonds to sup­press long-term in­ter­est rates and stim­u­late lend­ing and spend­ing. Thanks to Q.E., the cost of bor­row­ing money was pushed to next to noth­ing. This was a bo­nanza for those who make money from money - hedge-fund man­agers, pri­vate-eq­uity moguls, banks - and a dis­as­ter for savers, re­tirees and any­one on a fixed in­come. (Have you checked the in­ter­est your bank pays you on your sav­ings ac­count? Mine: .06 per­cent per year.)

The Ta­per Tantrum be­gan in May 2013, when Ben S. Ber­nanke, then chair­man of the Fed­eral Re­serve, an­nounced in con­gres­sional tes­ti­mony that later in the year the Fed would most likely start slow­ing - hence, "ta­per­ing" - its monthly bond buy­ing. On June 19, in a news con­fer­ence, Mr. Ber­nanke reaf­firmed that de­ci­sion: The Fed, he said, "cur­rently an­tic­i­pates that it would be ap­pro­pri­ate to mod­er­ate the monthly pace of pur­chases later this year." Be­fore the af­ter­noon was out, the Dow Jones in­dus­trial av­er­age had fallen more than 200 points, or 1.4 per­cent, and the bond mar­ket tanked as the yield on the 10-year Trea­sury bond rose to 2.36 per­cent, its high­est level since March 2012. The Fed quickly backed down and the ral­lies in the stock and bond mar­kets re­sumed.

The third round of quan­ti­ta­tive eas­ing ended last fall. And all of this year, the mar­kets have been chat­ter­ing about an ex­pected an­nounce­ment that the Fed will fi­nally - af­ter nine years - raise short-term in­ter­est rates in Septem­ber, by a mod­est 0.25 per­cent­age points. Yes, it would be a lit­tle painful to start hav­ing to pay a lit­tle more for short-term bor­row­ing and, yes, the net worth of Wall Street bil­lion­aires might in­crease at a slightly lower rate, but it looks as if the mo­ment is at hand to end the mor­phine drip. The case for rais­ing rates is straight­for­ward: Like any com­mod­ity, the price of bor­row­ing money - in­ter­est rates - should be de­ter­mined by sup­ply and de­mand, not by ma­nip­u­la­tion by a mar­ket be­he­moth. Es­sen­tially, the clever Q.E. pro­gram caused a wide­spread mis­pric­ing of risk, de­lud­ing in­vestors into un­der­es­ti­mat­ing the risk of var­i­ous fi­nan­cial as­sets they were buy­ing.

Sadly, the Fed, un­der Mr. Ber­nanke's suc­ces­sor, Janet L. Yellen, seems to be cav­ing. The wors­en­ing eco­nomic news from China, com­bined with un­cer­tainty about the Fed's plans, con­trib­uted to the re­cent sharp declines in stock mar­kets around the world.

All too pre­dictably, the pow­er­ful ad­vo­cates of the Fed's zero-in­ter­est-rate pol­icy have raced to its de­fense. Un­der the head­line "The Fed looks set to make a dan­ger­ous mis­take," Lawrence H. Sum­mers, the for­mer Har­vard pres­i­dent and Trea­sury sec­re­tary, wrote in The Fi­nan­cial Times, "At this mo­ment of fragility, rais­ing rates risks tip­ping some part of the fi­nan­cial sys­tem into cri­sis, with un­pre­dictable and dan­ger­ous re­sults." He then tweeted, "It is far from clear that the next Fed move will be a tight­en­ing" (a rais­ing of rates). Around then came a leaked note to clients from Ray Dalio, founder of Bridge­wa­ter As­so­ci­ates, one of the world's largest hedge funds, agree­ing with Mr. Sum­mers's as­sess­ment. He warned that the Fed might be so wed­ded to its "highly ad­ver­tised tight­en­ing path that it will be dif­fi­cult for them to change to a sig­nif­i­cantly eas­ier path if that should be re­quired."

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