Wanted: Fed Officials Who Care Less About Bond Market Volatilityby and
Former Fed Governor Stein Says Market Focus May Hurt Economy
Deutsche Bank Says Fed Shouldn't Hike Until Markets Beg
Damned if you hike, damned if you hold.
Such may be the feeling inside the Federal Reserve a week since it met the expectations of financial markets by postponing its first interest-rate increase since 2006, in part because “financial developments” threaten to impede growth and inflation.
Instead of showing gratitude for the reprieve, investors reacted to the continuation of ultra-easy monetary policy by dumping stocks and boosting bonds.
Now strategists and economists at Deutsche Bank AG are saying if the Fed wants to tighten monetary policy without roiling markets it must do so ultra carefully. “Our confident prediction is that the Fed will raise rates only when the market is begging for it,” they said in a Sept. 19 report to clients.
There is a sound argument for the central bankers to be in thrall to markets. The 2013 taper tantrum lives on in their memory and as recently as April they were discussing the dangers of catching investors off-guard. The concern is that by triggering market turbulence with higher rates, they could end up hurting rather than helping the economy.
To calm those fears, Fed officials including Chair Janet Yellen for years have offered the soothing rhetoric of gradualism. As former chairman Ben S. Bernanke said in 2004, the Fed “tends to adjust interest rates incrementally, in a series of small or moderate steps in the same direction.” His predecessor Alan Greenspan noted the previous year that he hoped “markets respond with a shrug” to decision-making.
More skeptical of putting markets so central to policy is former Fed Governor Jeremy Stein, whose views are laid out in a study formally published just this week by the National Bureau of Economic Research. He and co-author Adi Sunderam, a colleague at Harvard, suggest efforts to avoid spooking the bond market by treading carefully pose the risk of backfiring.
“It can be useful for monetary policy makers to build a reputation for not caring too much about the bond market,” wrote Stein and Sunderam, who found “an increasing emphasis” among officials on financial-market fallout.
Their analysis is based on the assumptions that a central bank has private information about where it would like its benchmark to be in the long run and is also averse to bond-market volatility.
The result is the Fed moves incrementally to avoid unsettling investors, “trying to fool the market” that its thinking behind closed doors is not that dramatic, according to Stein and Sunderam. The risk with this approach is that long-term rates may react aggressively to the piecemeal shifts as markets bet on more rate increases to come.
“This strong sensitivity of long-term rates to changes in the policy rate makes the Fed all the more reluctant to move the policy rate, hence validating the initial conjecture of the inertia,” they wrote. “In a world of private information and discretionary meeting-by-meeting decision-making, an attempt by the Fed to moderate bond-market volatility can be welfare reducing.”
The authors are at pains to say their analysis doesn’t give “much advice” to the current Fed as it tries to escape zero interest rates. Still, they propose a solution to how the Fed could be better off in the future when the economy is less fragile.
That would be to hire a “central banker who cares less about bond-market volatility than the representative member of society,” they said. “Appointing such a market-insensitive central banker can be thought of as a metaphor for building a certain type of institutional culture and set of forms inside the central bank such that bond-market movements are not given as much weight in policy deliberations.”