The Fed should show some spine

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 appears 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 applauds.

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 end of the 2008, the Fed dropped its benchmark short-term interest rate to around zero. It also began a programme with the Orwellian name of quantitative easing (QE), which helped to push the cost of borrowing money to virtually 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.

The Taper Tantrum began in May 2013, when then Fed chairman Ben Bernankeannounced 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 per cent, and the bond market tanked as the yield on the 10-year Treasury bond rose to 2.36 per cent, 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 autumn. 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 this month, by a modest 0.25 percentage points.

Yes, it would be a bit 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 it's time 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. QE caused a widespread mispricing of risk, deluding investors into underestimating the risk of the financial assets they were buying.

The only way to return the assessment of risk to something resembling normalcy is to stop the manipulation. That requires nothing less than serious intestinal fortitude from the Fed and a willingness to raise interest rates in the face of determined opposition from Wall Street.

Sadly, the Fed, under Mr Bernanke's successor, Ms Janet Yellen, seems to be caving in. The worsening economic news from China, and the 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 defence.

Former Harvard president and treasury secretary Lawrence Summers wrote in The Financial Times: "... raising rates risks tipping some part of the financial system into crisis, with unpredictable and dangerous results". He tweeted: "It is far from clear that the next Fed move will be a tightening (raising of rates)."

Around then came a leaked note to clients from Mr Ray Dalio, founder of Bridgewater Associates, one of the world's largest hedge funds, agreeing with Prof Summers' 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".

Last Wednesday, Mr William Dudley, president of the Federal Reserve Bank of New York, said September is not the time for the Fed to raise short-term interest rates. The argument for doing so seemed "less compelling to me than it was a few weeks ago", and he noted that "international developments have increased the downside risk to US economic growth somewhat".

Once the news of Mr Dudley's words got out, markets rocketed upwards. Crisis averted?

Thursday was also the first day of the annual central-banker retreat in Jackson Hole, Wyoming. The gathering's theme is the boring-sounding "Inflation Dynamics And Monetary Policy", but it's the perfect setting for these supposedly brilliant economists to figure a way out of this perennial Catch-22 once and for all. The right answer is self-evident: End the easy-money addiction, raise rates in September and begin the healing.


• William D. Cohan is the author of three books on Wall Street.

A version of this article appeared in the print edition of The Straits Times on September 02, 2015, with the headline 'The Fed should show some spine'. Print Edition | Subscribe