Is the Federal Reserve's Free Ride Ending?

The announcement on Friday, Dec.4, that the unemployment rate had fallen slightly from 10.2 % to 10 % surprised many, and perhaps dismayed some at the Fed. At its Nov. 3-4, 2009 meeting, the Fed announced that it expected to keep the fed funds rate at "exceptionally low" levels for an "extended period" of time. That announcement helped to fuel stock and commodities prices for the month of November. But after Friday's announced unemployment drop, stocks closed with only a modest gain, gold fell 4%, oil fell a little over 1% and the 10-year Treasury note fell about 0.75% in value (with an increase in yield of about 10 basis points). The dollar rallied.

These market reactions were spurred by the implication that the Fed will have to raise interest rates sooner than it expected. An interest rate hike would strengthen the dollar, reduce the value of gold, and push bond yields higher (and bond prices lower). The price drop in oil--seemingly odd because a recovering economy would be expected to consume more oil--is a reflection of the asset bubbling spurred by the Fed's cheap money policies. The huge amounts of cash pumped by the Fed into the financial system pushed down the dollar, thereby making oil more valuable in dollar terms. If the Fed begins to pull back on its accommodation, thereby strengthening the dollar, oil prices in dollar terms would naturally abate.

The Fed's predictive powers have been demonstrably lacking. It failed to see the implications of the growth in the mid-2000s of looney mortgages (the kind given to people who couldn't repay), the misplaced risks and rewards of the securitization process (where Wall Street made monstrous amounts of money from doing deals--including excessively risky deals, recklessly stupid deals and irredeemably bad deals), the increasing opacity of the financial system's true condition caused by derivatives and then derivatives of derivatives, and finally the monumental blockheadedness of concentrating at AIG credit default swaps insuring hundreds of billions of dollars worth of mostly mortgage-related investments. One wonders whether the Fed has underestimated the pace of the economy's recovery.

On one level, we hope it has. Continuation of the Great Recession much longer could inflict lasting damage to consumers, workers, businesses and investors that might lead to the stagnation that has bedeviled Japan since its massive asset bubble burst in 1989-90. There, people seem to have lost faith in just about everything except the government. This was most recently demonstrated by the Japanese government's cancellation of plans to privatize its postal system (which is not only a mail carrier, but an enormous bank and insurance company). The U.S. government's greatly expanded role in the economy could easily become permanent if the private sector doesn't revive soon.

But a Christmas present in the form of improved economic performance could lead to volatility in the financial markets. A lot of players (they used to be called investors, but today long term investing is about as trendy as a large SUV) have borrowed dollars at cheap, short term rates, converted them into other currencies and invested in longer term plays denominated in other currencies. Or else they invested in oil or oil futures, betting that continued bottom of the barrel interest rates would push oil prices ever higher in dollar terms. Or they took heart from the Treasury securities market's improbable rally this year and the Fed's ongoing trillion dollar program to buy Treasuries and mortgage-backed securities, and used cheap borrowed money to purchase higher yielding long term securities they thought would be propped up by the Fed's massive money print. Or they jumped into the stock market with the hope that the Fed's gusher of liquidity would continue to push stocks higher, even after a 60% rally this year.

All this activity was premised on the Fed correctly foreseeing economic stagnation and keeping short term interest rates virtually at zero, as it publicly proclaimed. If the Fed again turns out to be wrong, and has to hike rates sooner than expected, a lot of free rides will end. The players who have borrowed short and invested long may well have to unwind their positions, learning the hard way that not matching the duration of your borrowings with the duration of your investments entails risk. That could lead to volatility in the financial markets. If the volatility begins to create systemic problems, the credit crunch could again rear its hideous head and banks may again become catatonic. Then we'd probably have the much feared double-dip recession.

The Fed meets again on Dec. 15 and 16, 2009. Don't expect any rate hikes then. But the Fed may be compelled by continuing good news to modify its promise (that's how financial markets players have been viewing it) of ultra low interest rates. If it does, the speculators in the financial markets might have to make painful adjustments (as they probably already are).

Even as the Fed for the past year has given banks and other financial market participants a virtually free ride on borrowed money, it's gotten a free ride in terms of monetary easing. With banks making almost no new loans and pulling back existing credit, no amount of Fed accommodation seemed to have any impact on consumer prices. The Fed could keeping shoving printed money off its loading dock and not pay the price of monetary policy gone wild.

But the law of unintended consequences always lies in wait to ambush federal economic policy. The Fed didn't intend for its monetary easing to stimulate asset speculation here and abroad, even though it should have been sensitized to that risk by its role in the pumping up the real estate bubble. Chairman Bernanke's pledge of greater transparency of the Fed's thinking is a good idea. But when the Fed starts to play that most dangerous game--publicly predicting the future course of the economy and interest rates--it had damn well better be right. Or the rest of us will pay the price.