Monetary policy should seek to avoid major surprises


In recent writings, I have laid out the strategic case against the Federal Reserve tightening this week. There is a compelling tactical case as well.

Monetary policy should seek to avoid major surprises.  Right now the fed funds futures market is assigning only a 28 percent chance to a September tightening. In the last 20 years, the Fed has never tightened without guiding the futures market to at least a 70 percent chance of a tightening.  So a move now, given how expectations have been managed, would be an extraordinary shock at a highly uncertain time.

To find a relevant precedent, one has to go back to 1994, when the Fed raised rates by 25 bps despite the market assigning only about a 30 percent chance (around what is expected now) of a tightening.  What followed was dubbed by Fortune Magazine as the Bond Market Massacre.”  Over the ensuing nine months, the interest rate on the 10-year bond rose by 2.2 percentage points — nearly twice as big an increase as any subsequently — with mortgage rates rising in tandem.   Volatility spiked dramatically across the world, and Orange County had the then-largest municipal bankruptcy in U.S. history.  Mexico and Argentina moved towards financial crisis.

There is a point here quite separate from the issue of what monetary policy should be.  Communication is a key part of the art of monetary policy.  The Fed for a generation has caused its tightening moves to be anticipated because it learned from the 1994 experience.   The same approach should be taken going forward.  Even if it were otherwise a good idea to tighten, no adequate predicate has been laid for a rate increase this week.


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  • Peter Nowicki

    The markets need discipline and rates should have been increased years ago from the emergency levels that might have been required after the crisis. The Fed is in a “liquidity trap” which requires rates to stay at emergency levels and that fuels the bubbles in equities, Commercial and Residential Real Estate and financier assets. The Fed needs to do the “right” thing to ensure that monetary policy does not fuel bubbles which is turn exacerbate income inequality. The fact that a prominent Democrat seeks to keep rates at zero is also a worrisome factor as it helps the incumbent party keep the party going. The music has to stop and the Fed has to do the “right” thing for the country.

  • lukelea

    Nice point, not often heard.

  • Steve Robinson

    I would argue the 1994 tightening cycle was a long-term success, volatility in the bond market aside. Interest rates normalized and as a consequence excesses in financial markets and real estate were prevented from forming into bubbles, and the Fed’s credibility was preserved. You could make the argument while their was less short-term volatility at the time, the greater long term systemic instability occurred after after the late 90’s and 04-2006 tightening cycle. Perhaps if we had the stomach for a little more volatility at the time, and raised interest rates beyond the expectations of the futures market, the severity of the ensuing crises could have reduced. As for Argentina being in financial crisis, it’s difficult to think of a period of time that that country wasn’t lurking towards an economic apocalypse. It’s just what they do.

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