Monday, August 24, 2009

Get Ready for Interest Rate Shocks

One of the important messages coming out of the central banker's annual retreat in Jackson Hole, Wyoming is that once the crisis is over the Federal Reserve's (Fed) tightening of monetary policy may be abrupt. If so, increases in short term interest rates will not be gradual but jarring. The reasoning behind this approach, as I understand it, is that (1) since there could be political pressures to monetize the government debt and (2) given the large amount of existing liquidity that needs to be drained the Fed's exit strategy needs to be unmistakably clear in communicating that it will not tolerate the unanchoring of inflationary expectations. Here is the New York Times:
A growing number of economists and some Fed officials say the shift to tighter monetary policies and higher interest rates, though unlikely to start until at least the middle of next year, may have to be much more abrupt than normal if they are to prevent inflation two or three years from now.

“When you get into a crisis like this, gradualism is not the right strategy,” said Frederic S. Mishkin, an economist at Columbia University who was a Fed governor from 2006 until 2008. “Of course, when things turn around, you have to be aggressive in the other direction.”
And here is the Wall Street Journal on the talk Carl Walsh gave at the retreat:
[O]nce the Fed does start raising the federal-funds rate out of its current record-low range near zero, "it should be increased quickly," Mr. Walsh argued. "There is no support for raising rates at a gradual pace once the zero rate policy is ended."
This rhetoric is sounding so Paul Volker-like. It remains to be seen, though, whether the Fed could actually make such abrupt changes in monetary policy. There are two major obstacles to such an approach. First, now that the global economy has become addicted to a low interest rate policy, any drastic tightening will amount to a painful interest rate shock. Second, tightening policy may make the budget deficits even larger and make it more costly to finance, a point alluded to in the New York Times article:
Indeed, the Federal Reserve’s “exit strategy” could lead to a clash with the Obama administration. The White House plans to release its newest budget estimates next week, and administration officials said that the 10-year deficit will rise to $9 trillion — a big jump from its earlier estimate of $7 trillion.


In the future, Fed officials could feel more pressure to further tighten monetary policy as a way of countering the government’s deficit spending. The immense amount of borrowing could push up long-term interest rates, if foreign investors balk at buying up United States debt.
Of course, all of this analysis assumes the Fed knows when the time is right to begin its exit strategy. As noted in my previous post, however, even this assumption is questionable. Fed policy over the next few years should be a doozy to watch.


  1. Is a drastic increase in interest rates a "shock" if it is anticipated ? If the Fed is talking about it , shouldn't markets be pricing that in ? Expectations theory of term structure and all that.... (I suppose its the timing thats the shock, not the tightening per se?)

  2. ECB:

    You are correct that this shock should be anticipated and therefore is not a shock in the standard sense. However, given the debt burdens, the addiction to low interest rates, and the expected sluggish recovery any sharp increase in rates should still have a negative real effect even if it is known in advance. In short, I think there are currently enough rigidities in the economy that even an anticipated policy move will have a real effect.

  3. David,

    I don't know if I would describe the rate-shock strategy as consensus. Donald Kohn expended some capital by publicly denying the need for it during Carl Walsh's Q&A, and typically Kohn has reflected Bernanke's thinking in these forums.

    The Fed, for now, is getting to have their cake and eat it with respect to the markets. On the one hand, the Fed tells us it sees no need to tighten for some time; and on the other hand, that it sees no threat to the anchoring of inflation expectations. The markets agree -- again, for now. And that is why a change (towards rate-shock) would, in fact, shock the markets.

    What consensus does believe is that the output gap will control inflation until at least 2011. This is a critical assumption -- one that the Fed actively promotes. If the Fed is right, it will avoid having to raise rates quickly. Of course, the chances of that are low.

  4. I am sorry but words from bankers and Fed bureaucrats are usually intended to deceive rather than reflect reality. The bottom line is that there is no way that abrupt increases will be palatable just before the Congressional elections. They are even less likely to be palatable in 2011 because Obama and his team will be eager to concentrate on creating the best conditions that are likely to result in getting the President re-elected.

    I suspect that the statements are designed to put downward pressures in the gold, oil and commodity markets and to lend support to the currency. But the statements are unlikely to work as it becomes clear that the economy is not as strong as advertised and that further quantitative easing is on its way. The best approach for the prudent investor is likely to involve buying the precious metals during the regular corrections and to hedge one's USD positions by being long energy companies that are flush with cash and have reserves in politically safe areas in the world.