Wall Street Hates the Fed, Not Low Rates
The Federal Reserve is hurting savers by keeping interest rates low. Low rates cause inflation. Low rates cause financial instability.
So you would think if you talked to a bunch of people in the finance industry, watched CNBC and read articles in the financial press. It isn't so much low interest rates that Wall Street despises; it’s when interest rates are lowered by Fed policy.
It seems like Wall Street should have the opposite reaction when the Fed pushes down rates. After all, lower rates mean higher asset values, at least mathematically. That’s why they used to call low rates the “punch bowl,” and periods of easy monetary policy “the party.” It seems like asset managers, buy-side firms, and anyone with a net long position in the stock, housing or commodity markets -- read, almost everyone -- should love it when the Fed lowers rates.
So why do so many Wall Street people seem to hate it? It’s a mystery, but I’ve come across three theories. I’ll call them the Rentier Theory, the Fed Whale Theory and the Behavioral Theory.
The Rentier Theory is very simple: Wall Street people, directly or indirectly, make their money by servicing clients. Those clients are rich people. And, if the theory is right, rich people, on average, are owed money. And when there’s inflation, it destroys the wealth of rich people. So since the generally (but not universally) accepted wisdom is that low rates are inflationary, Wall Street’s worries about low rates are really just worries about the welfare of their clients.
Now, if low rates don’t really affect inflation very much, then this explanation is a little weak. When rates fall, income from new bonds falls, but the price of old bonds rises. This means that when the Fed lowers rates, it redistributes wealth from rich people with long investment horizons (who live off their income, and are thus called rentiers) to rich people with shorter investment horizons. Unless Wall Street’s clients are very heavily skewed toward the former, the Rentier Theory doesn’t really make sense in this context.
Next we have the Fed Whale theory. This theory says that Wall Street people like to be able to control, or at least understand, the movements of the market. That makes sense -- we humans like to understand things, and we like to be able to control our destinies. The Fed is so powerful that even the entire unified might of the finance industry can’t overcome it, the way it can overcome a rogue trader or someone who corners a market.
Brad DeLong, an economist at the University of California, Berkeley, put forward this hypothesis back in 2013, in a post called “Moby Ben.” He makes an analogy between Bruno Iksil, the London Whale, and former Fed Chairman Ben Bernanke. Iksil’s trade was broken when a critical mass of traders took the opposite position. But you just can’t do that to the Fed, which can print money. Only a spike in inflation would have brought down Moby Ben, and -- despite the many predictions to the contrary -- that spike never materialized.
More generally, the Fed Whale theory says that uncertainty over what the Fed will do just gives finance people a headache. The less active the Fed looks, the more asset managers, traders and risk managers can turn their attention to things that have a more-or-less known probability distribution, like the weather.
Finally, there’s the Behavioral Theory. Investors don’t seem to do a very good job measuring their own returns, and that almost certainly means that they don’t do a good job of benchmarking. If they get 7 percent in a year in which a broad-based index rises 10 percent, many think they made out like bandits, and if they lose 2 percent in a year in which a broad-based index declines 5 percent, many think they crashed and burned.
Now here’s the second part of the Behavioral Theory: The better investors think they’re doing, the higher the fees they’re willing to pay. When safe interest rates are 8 percent, an asset manager can get his client a 6 percent return -- obviously a bad result -- and the investor may still feel good enough to shell out a 2 percent fee. But when safe rates are 0 percent, even if an asset manager gets his client 1 percent -- a good result -- that 2 percent fee will knock the investor from what looks like a gain to what looks like a loss.
So this hypothesis says that Wall Street hates low rates because they make it hard to charge high fees.
All of these theories seem interesting, and yet all have weaknesses. The Rentier Theory doesn’t seem to apply to all or even most rich people. The Fed Whale Theory seems to underestimate Wall Street’s ability to cope with risk. And the Behavioral Theory assumes that investors stay irrational forever. It’s hard to tell which theory is the right one, or whether these are all just pieces of the elephant. We may never know exactly why Wall Street hates easy monetary policy with such a violent passion.
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Noah Smith at firstname.lastname@example.org
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