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Thursday, March 28, 2024

Guest Post: The Helicopter Departs

Courtesy of Tyler Durden

Submitted by TimmyM

The Fed move to raise the discount rate on Feb. 18 has initiated a discussion of the timing of the removal of accommodation. Unfortunately, framing the subject as being relevant to accommodation is a mistake. The implementation of a near zero interest rate policy is just another component of emergency measures used to cure a systemic bank run. The emergency measures need to be viewed completely separate from the setting of a policy rate for economic management purposes. The potential raising of the Fed target rate from near zero to near 1% should not be called a tightening of monetary policy.

There exist many harmful side effects of an emergency rate policy.

This emergency rate policy imposes an extreme penalty on risk averse savers and retirees. It also squeezes bank margins in so far as a portion of all bank balance sheets are asset sensitive. This emergency rate policy is fomenting harmful speculative global carry trades with potentially devastating consequences. It is apparent that the continuation of an emergency rate no longer has any marginal benefit and is overall unproductive.

Recent political events such as the election of Scott Brown in Massachusetts, the rise of the Tea Party movement and the CPAC poll supporting Ron Paul are all strong indications of the growing populist anti-bank, anti-central bank and anti-bailout public sentiment.
Historically, a politicized Fed has been associated with  an easy money inflationary policy. But, an argument can be made that the current populist sentiment reverses this legacy perception at least temporarily. This new populism views a near zero interest rate policy as an unproductive bank subsidy. While many observers  find it difficult to believe the Fed will also end quantitative easing, the Fed can go through with this in part because of this new populist mandate. The populist movement can be viewed as providing the Fed political cover for the removal of emergency measures.

The near zero interest rate policy also distorts loan and security pricing. The well established practice of banks setting the prime rate at 3% above the Fed target rate presents a problem for banks as they attempt to protect their net interest margins. A similar problem exists in the way both outstanding and new loans and securities are priced off of other short-term indices as well. It could be that if LIBOR was to go up, the spread of loans and securities to LIBOR would contract in response to the higher nominal rate paid rather than some association to credit spread.

A difficult to quantify risk of emergency Fed policy is the risk of surprise unwinding of leveraged global carry trades. The presence of these positions destabilizes all markets, and to the extent all the risk markets are correlated by ubiquitous carry trading the financial system is diseased by lurking illiquidity events. Speculative leveraged finance should by reigned in by both regulatory reform and the removal of emergency measures.

In so far as the markets hold the impression of the Fed as having an inflationary bias, this impression could be partially corrected by the unproductive presence of these emergency measures. The Fed may be coming to believe that asset pricing and bubbles are something to be foreseen and prevented after all.The political cover of the populist movement as well as the Fed’s need to retain their regulatory authority has aligned these various interests for us to now expect the appearance of a more hawkish institution. The implications of this will be seen in the probability of a flatter curve and the risk of deflation.

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