Raising Rates will be Curtains for Independent Central Banking
March 16, 2015
Independent central banking—meaning central banking presumably free of political influence—is something of a misnomer. Political factors and considerations have always played a role. I would actually argue that the chief function of the Federal Reserve is to protect the Treasury market. The perception of Federal Reserve competence has underwritten this independent stance. If the Fed raises rates in the coming months, beware. It will cause spreads to widen, maybe radically so. The perception of competence will be challenged and will set the stage for other interests to take the reins in defining winners and losers in the monetary policy game. For this reason it is unlikely that the Fed will raise rates as most other interest rates are easing.
Central banking has been largely independent of overt political influence. Since WWII, the Fed and other central banks have done the job of price stability and relatively healthy employment well enough that politicians have stayed out of it. Price stability and health employment aren’t taken for granted anymore. Neither is independent central banking.
Bumping interest rate up and down isn’t having the same effects which we are accustomed. In fact, the dominant view is that the Federal Reserve, and by implication other central banks, serve wealthy vested interests at the expense of everyone else. This criticism is fair enough, but it is missing the bigger point: the central bank tools are not working.
Because they are not working, central banks have little choice but to keep funding cost ridiculously low, fueling risk appetite for liquid assets. Via LTRO I and LTRO II, they offer duration money at short-term rates to banks to keep them solvent. They purchase government securities, setting long-term interest rates so that it creates incentives to refinance and issue more debt rather than pay down. This is all done in the hope that it will trigger a meaningful recovery, but it looks like it is creating even more balance sheet problems.
I think that Yellen and the Fed mind-trust figured this out a while ago. What QE gives in stimulus it takes by incentivizing more reckless debt issuance. It isn’t solving insolvency at all. Tightening is the right thing to do conceptually. Pragmatically speaking, it is not.
Any tightening in what is at best a fragile environment has the potential to cause a real meltdown. If there is one thing you can trust, credit spreads always widen in rising rate environment. As the Fed "eases" (suppresses rates), investors chase yield and force a compression of credit spreads. When the Fed reverses course investors flee credit-risk-bearing assets for sovereign debt, forcing credit spreads higher. Meltdown or not, the end result will be selling in the credit space.
Politicians are already anxious about the winners and losers that unconventional monetary policy is creating. In some cases, it is austere Germans versus “Club Med”. In other cases it older savers that depend on interest accrued that feel screwed. In the case where its policies create winners and losers, it is not the Fed’s job to decide who wins and loses.
Further, another misstep by the Fed will lead to a crisis of credibility. Opinion will quickly shift to a different view: not only do Fed policies create winners and losers; everyone loses by Fed incompetence. Politicians will surely feel tempted to take over the reins. I’m not saying this is a good idea. But the precondition for independence is the perception of competence.
The Fed raising rates will have bad consequences for the market. It is a needed medicine just to get back to normal. But if the patient has a life-threatening reaction like it did in 2008, it will signal other, more rapacious, physicians to start a different care plan.