The More They Talk, The Less They Say
Perhaps the entire period of Fed ‘glasnost’, in which they did their best to telegraph everything they were going to do for the next six months, was setting up for this. As the new year dawns, it seems that we are hearing more and more salvos from Fed speakers suggesting they could hike rates at any time and they know they will someday need to do so. Maybe they think we will take them seriously. But no one in their right mind believes that the FOMC would do anything significant with Unemployment around 10%.
Indeed, it seems to me that all the talk about the necessity to eventually hike rates is like Cleavon Little holding a gun to his own head in “Blazing Saddles” and telling everyone to stay back “or the n—– gets it!” Hiking rates at this point would be potentially catastrophic without having any meaningful redeeming effect to warrant the risk. This isn’t to say that it is impossible to make a case to move rates away from zero; merely that it would be a foolhardy move on a risk-reward basis. Not, mind you, that such considerations have stopped this Fed.
However, consider how silly it it is to publicly fret on one hand about the potential impact on interest rates when the Fed’s mortgage purchase plan ends while on the other hand threatening to hike rates directly. I suspect they are just trying to talk the curve flatter somehow. They are likely concerned about the continued frothiness of forward inflation indicators; 5y5y forward inflation, as measured (correctly) by CPI swaps, is at 3.28%. That’s not as high as it was last year, but is considerably higher than it was in the summer of 2008 when the Fed was frightened by the inflation outlook. And, as noted yesterday, the Fed seems to believe very strongly in the importance of keeping inflation expectations “anchored.”
So today’s blather was provided by Kansas City Fed President Hoenig, who suggested that “near-zero rates may impede financial market recovery” (according to Bloomberg).
Now, that’s a crazy statement. Raise rates, and money will flow to money market funds and out of bonds and equities where money is lent for longer terms. It will flow into bank accounts rather than being spent. It will flow away from term lending at banks (it has already done so, even with near-zero rates) into government securities. It might help repair the personal balance sheets of “passbook savers” a tiny bit, but by driving up mortgage rates and helping to drive down home prices and equity prices that effect would be completely overwhelmed. All of this is bad for economic recovery, and that cannot help financial market recovery! The only possible way I can see that low rates might impede recovery in the financial markets is if somehow low rates are impairing confidence, but that’s nuts.
Hoenig did say that while the Fed should eventually lift nominal rates to the neighborhood of 4%, or roughly 2% real rates, and that balanced policy should occur “sooner rather than later” because the “recovery is gaining momentum,” it will still be “some time” before policy actually becomes more balanced.
As if to underscore the threat – and make no mistake, there is an implied threat here that banks should release some of their mark-to-market assets like Treasuries and do some more lending – the Fed released a joint communique from a flock of financial regulators including themselves, the FDIC, OTS, the National Credit Union Administration, the Office of the Comptroller of the Currency, and the Federal Financial Institutions Examination Council State Liaison Committee. It read in part:
The Federal Reserve Thursday released an advisory reminding depository institutions of supervisory expectations for sound practices in managing interest rate risk. This advisory, adopted along with the other financial regulators, reiterates the importance of effective corporate governance, policies and procedures, risk measuring and monitoring systems, stress testing, and internal controls related to the interest rate risk exposures of depository institutions…
…The financial regulators remind depository institutions that an effective interest rate risk-management system does not involve only the identification and measurement of interest rate risk, but also addresses appropriate actions to control this risk. If an institution determines that its core earnings and capital are insufficient to support its level of interest rate risk, it should take steps to mitigate its exposure, increase its capital, or both.
Now, I don’t think this is telling bankers anything they don’t already know. I’ll go further: I don’t think these regulators can tell bankers anything they don’t already know about interest rate risk control. (And that is the big problem, incidentally, with the way the regulatory environment is developing. Regulators – and even worse, Congressmen – judge risk after the fact, as in “did you lose money?” Of course, risk control is conducted a priori, and can’t be evaluated merely on the basis of the one result that actually occurred from the universe of possible results. But there’s no way to explain that, using only monosyllabic words, to a Congressional committee.)
But what this release does do is create a bit of risk that a selloff on a strong number tomorrow could be more extensive than it would otherwise be (who is going to go out on a limb and be long after strong data after that lecture on risk?!). Now, I am on record as saying I think the Employment number is somewhat more likely to be weaker than the forecasts are calling for, but now I think the trading risks are more balanced: better chance of a rally, but a selloff might be steeper. Tough call.