Commentator Steve Leisman, writing in the Wall Street Journal Online, suggests that just maybe the Federal Open Market Committee is being too clear about its intentions.
By appearing less predictable, the Fed could help send those long-term rates higher by reducing the amount of money flowing into the so-called carry trade. These usually are highly indebted bets speculators have taken precisely because they've been relying on this so-called commitment by the Fed to raise rates at a measured pace...
Under the carry trade, investors borrow short and lend long. For example, if you went to a bank and borrowed money for two-years at 3.5% and then bought a 10-year bond yielding 4.5%, you'd be a card-carrying member of the carry-trade club.
You'd pocket a gain of one percentage point. And what exactly is your contribution to society? You'd assume the risk that long rates won't collapse without a proportional decline in short-term rates. More importantly, you are doing a business that used to be the province of banks: taking short-term liquidity and making it available long term.
The impact is, ostensibly, to undo the Fed's work. By driving up short-term interest rates, it is apparently the Fed's hope to bring long-term rates along. But the more people pile into the carry trade, the more minimal the effect on the long end of the market.
As interest rates rise, so the story goes, carry-trade profits require ever greater leverage by the players, which they are willing to take on because those crazy central bankers are being just so darn predictable. But the Titanic is heading straight for the iceberg.
Why is all this risk-taking a problem? Because it could be setting the stage for a highly leveraged fall. John Lonski, economist at Moody's Investor Services, noted this week that the "abundance of liquidity invites an increase in risk taking that can amplify a future economic slowdown." He continues, "To the degree liquidity induces a higher tolerance of risk, the future incidence of default will be greater than otherwise.''
Translation: a low fed-funds rate, to which I would add an overly predictable fed-funds rate, causes some investors to take too much risk that can make things worse once the liquidity is taken away.
Let me see if I have this straight. A clear indication from monetary policymakers about how they intend to behave is a good thing, except, or course, when it's a bad thing. Pretty tough world.
At the beginning of the article, Leisman does clearly present the essential issue in this particular communications conundrum.
When the Federal Reserve meets next week, all ears will be tuned to whether the central bank continues telegraphing to markets it will raise interest rates at "a measured pace."
Wall Street has taken the phrase as a commitment from the Fed to raise its overnight lending rate for banks in quarter-percentage-point increments. Fed officials, of course, say it's nothing of the sort -- a forecast, not a commitment.
The difference is important...
Right. But why "Wall Street" is confused about the difference between forecast and commitment is a bit of a mystery to me. Here -- to provide just one of a dozen or so examples I could recite -- is what Governor Ben Bernanke had to say just last week.
One may reasonably ask when this process of removing policy accommodation will stop. This question is not straightforward to answer. In particular, it is not helpful, in my view, to imagine the existence of some fixed target for the funds rate toward which policy should inexorably march. Instead, the correct procedure for setting policy requires the FOMC to continually update its forecast for the economy, conditional on all relevant information and on a provisional future path for monetary policy. The funds rate will have reached an appropriate and sustainable level when, first, the outlook is consistent with the Committee's economic goals and, second, the slope of the term structure of interest rates is approximately normal, as best as can be determined... the neutral policy rate depends on both current and prospective economic conditions. Accordingly, the neutral rate is not a constant or a fixed objective but will change as the economy and economic forecasts evolve.
That seems like a pretty clear conditional -- i.e. forecast-like -- statement to me. Maybe investors would rather buy the proposition that there is some secret handshake buried in there. To that I say, caveat emptor, dudes.