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The Fed Should Surprise Us -- WSJ

24 Jun 2017 6:32 am

Its habit of calming markets may help set up a crash
By Sebastian Mallaby 

This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the US print edition of The Wall Street Journal (June 24, 2017).

With every passing month, the U.S. economy feels, ominously, more like it did in 1999 and in the mid-2000s. Both were times when a promising mix of full employment, low inflation and buoyant spirits gave way to a financial convulsion that triggered a recession. Unfortunately, the Federal Reserve under Janet Yellen is ignoring a relatively painless policy that would reduce the danger of a sequel.

The debate surrounding the Fed's interest-rate decisions tends to follow a familiar script: Should the federal-funds rate be nudged lower or higher? Inevitably, this means parsing conflicting signals: Lately, inflation has been below the Fed's annual 2% target, which argues for low interest rates; but at the same time, unemployment is very low, and loose money may have pumped up asset prices unsustainably, both of which argue for higher interest rates.

A different debate could help the Fed out of this bind. Even if Ms. Yellen's current, rather gradual pace is appropriate, the Fed can reduce the odds of a financial bust by tweaking the manner of its tightening.

To do so, the Fed should examine a tenet of the central-banking faith: that transparency is always virtuous. By being less transparent -- and reserving the option of deliberately ambushing investors with a shock move -- the Fed could discourage them from taking too much risk.

Such an ambush would unsettle markets, to be sure; but that would be the point. The painfully learned lesson from the late 1990s and mid-2000s is that excess financial serenity leads to excess risk-taking, which in turn increases the chances of a blowup. In the first case, that meant the tech bust of 2000; in the second case, it meant the planet-shaking subprime-mortgage meltdown. Since market convulsions caused the last two recessions, reducing the probability of the next one must be a Fed priority.

This link between serenity and excessive risk-taking isn't just an observation about market psychology. It follows from the so-called Sharpe ratio, named after William Sharpe, a Stanford economist who won a Nobel Prize in 1990. The Sharpe ratio states that the attractiveness of an investment -- a stock, a bond or some bundled combination of financial instruments -- can be measured by its expected return (technically, the excess return over the risk-free rate, such as on Treasury bonds) divided by its expected volatility. A financial bet that you think will earn, say, 6% a year is extremely attractive if its volatility is low. But if markets are choppy and the risk looks large, 6% won't be worth it.

It follows that, when risks seem modest, Wall Street borrows to make bets that look great based on the Sharpe ratio. Many algorithmic trading systems do this automatically: They are programmed to borrow more and bet bigger when recent market history indicates serenity. Human traders do this too, loading up on positions as volatility falls, in a strategy known as "vol targeting."

Then there is what Wall Street calls "selling volatility." When markets are calm, a tempting way to juice returns is to sell insurance against future disruptions. Traders do so by selling options, collecting a premium for shouldering the risk that markets could collapse. The more traders do this, the more they induce trading behavior that makes their predictions of stability come true. The expectation of calm becomes self-fulfilling, until a shock causes a spike in fear -- at which point the alchemy of options intensifies the instability. A similar dynamic exacerbated the dramatic crash of 1987.

In the past month, I have heard traders in London, New York and Singapore worry about the dangers of volatility selling. Frank Brosens, the co-founder of Taconic Capital, a hedge fund, has tried to gauge the size of this practice in U.S. equity markets: He isn't alarmed enough to bet aggressively on a collapse, he told me, but he has bought some cover against the risk of one.

The longer the eerie calm in the market continues, the greater the danger that vol selling will spread. And the longer the real cost of short-term borrowing can be counted upon to remain negative or near zero, the likelier it is that financial excess will ultimately destabilize the economy.

Given all this, why does the Fed accentuate this risky calm? Part of the answer is that its leaders don't like to play the villain. Chastened by the experience of the 1970s, they accept that they must raise interest rates and destroy jobs when inflation threatens. But the equally hard lesson of 2008 hasn't yet been absorbed: that they should embrace modest, short-term market instability to head off truly disruptive crashes over the horizon. Instead, the calmer markets remain, the prouder the central bankers feel.

The other part of the answer is that, facing an immensely complex task, central bankers are fatally attracted to simplicity. In the "monetarist" era of 1979-82, the Fed, like many central banks, presumed to steer economies by targeting a single measure -- the rate of growth of money. But it soon abandoned this project because "money" proved hard to define or measure.

Similarly, in the 1990s, many central banks aspired to abolish exchange-rate volatility by pegging their currencies to the dollar. That project was ditched when it turned out that weaknesses within an economy can turn a currency peg into a currency crisis.

The central-banking fashion now is to target inflation and to communicate prodigiously about coming interest-rate adjustments. Fed officials publish their expectations for interest rates over the next three years and telegraph changes via statements, speeches and interviews. But stable finance often matters more than stable prices. And transparency about future interest-rate moves can induce disruptive speculation.

In January 2004, some three years before the subprime mortgage bust, the Fed saw financial risks building. With inflation low, the federal-funds rate was down at just 1%, which ran the risk of pumping up asset markets unsustainably. "The potential snapback effects are large," Fed Chairman Alan Greenspan acknowledged at the Fed's first interest-rate meeting that year. "In my view, we are vulnerable at this stage to fairly dramatic changes in psychology."

Like today's Fed, in other words, Mr. Greenspan and his colleagues faced the danger that the interest rate that would stabilize consumer prices would also destabilize asset prices. The Fed could have escaped this dilemma by acting less predictably. Instead, it telegraphed its intentions and avoided surprises. The resulting calm in the markets was "a central banker's dream," as one of Mr. Greenspan's colleagues said. "The market now pretty much anticipates how we're going to respond to various events," Mr. Greenspan rejoiced in May 2005. The Fed's interest-rate moves, he added, were causing "as little reaction...as possible."

With the unfair benefit of hindsight, we know that this lack of market reaction was a curse: One central banker's dream became another central banker's nightmare. The Fed needs to absorb this lesson -- and soon.

--Mr. Mallaby is a senior fellow at the Council on Foreign Relations and the author of "The Man Who Knew: The Life and Times of Alan Greenspan" (Penguin Press).

(END) Dow Jones Newswires

June 24, 2017 02:32 ET (06:32 GMT)

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