The Federal Reserve did not budge on its interest rate target last week. They sure dropped enough hints for several months that something was in the works. The financial media follows this subject without pause, weighing inflation against GDP growth. The real narrative should run on two totally different tracks.
Track one is consideration of systemic stability. Low interest rates have propped up insolvent commercial banks long enough for them to disgorge most of their bad mortgage paper. Institutional investors desperate for yield were dumb enough to buy this paper thinking they could get more yield at a discount. The Fed now has to open back channels to money market funds to keep the system from unraveling in the event it raises rates. Read my article on the Fed's imaginary toolbox for a refresher.
The second track is the prosaic domain of human psychology. The Fed releases its minutes after every board meeting. It is increasingly obvious that most of the board members do not know how to get out of the mess the Fed has made for itself with six years of low rates. The intellectually honest ones, like Stanley Fischer, know that what they don't know won't matter if they can innovate fast enough in another crisis. The President and Congress will play catch-up in a crisis with new rules preventing investors and savers from escaping the Fed's emergency measures.
This endless waiting game would never have happened if the Fed had gradually normalized interest rates starting in 2010. It would have been painful for a lot of banks and mutual funds that would have faced insolvency after rapidly selling whatever bundled securities the Fed was unwilling to buy. Smart policy could have forced banks to consolidate. Instead we got dumb policy that forced yields to zero, drove conservative investors into assets outside their risk profiles, and destroyed price discovery in equity markets.
The Fed's real mission is to keep the financial system in working order. The imperfect humans operating the Fed's inner levers are as prone to panic as the rest of us without leaders who will keep them calm. Systemic stability requires emotional stability. Raising rates after October will test the readiness of capital controls and other ideas under the "break glass in case of emergency" sign. Keep calm and carry on.
Track one is consideration of systemic stability. Low interest rates have propped up insolvent commercial banks long enough for them to disgorge most of their bad mortgage paper. Institutional investors desperate for yield were dumb enough to buy this paper thinking they could get more yield at a discount. The Fed now has to open back channels to money market funds to keep the system from unraveling in the event it raises rates. Read my article on the Fed's imaginary toolbox for a refresher.
The second track is the prosaic domain of human psychology. The Fed releases its minutes after every board meeting. It is increasingly obvious that most of the board members do not know how to get out of the mess the Fed has made for itself with six years of low rates. The intellectually honest ones, like Stanley Fischer, know that what they don't know won't matter if they can innovate fast enough in another crisis. The President and Congress will play catch-up in a crisis with new rules preventing investors and savers from escaping the Fed's emergency measures.
This endless waiting game would never have happened if the Fed had gradually normalized interest rates starting in 2010. It would have been painful for a lot of banks and mutual funds that would have faced insolvency after rapidly selling whatever bundled securities the Fed was unwilling to buy. Smart policy could have forced banks to consolidate. Instead we got dumb policy that forced yields to zero, drove conservative investors into assets outside their risk profiles, and destroyed price discovery in equity markets.
The Fed's real mission is to keep the financial system in working order. The imperfect humans operating the Fed's inner levers are as prone to panic as the rest of us without leaders who will keep them calm. Systemic stability requires emotional stability. Raising rates after October will test the readiness of capital controls and other ideas under the "break glass in case of emergency" sign. Keep calm and carry on.
