Memo to Fed and ECB: Raise Rates

Dear Sirs,

You have slashed rates to the bone and you are now signaling your commitment to keep them there "for as long as it takes". Assuming your aim is to revive credit markets, i.e. generate a "healthy" amount of credit demand and creation for the greater benefit of the economy, what you are doing is mostly wrong.

Oh, I do understand that your actions and statements are in line with academic monetary policy theories. But, they are misplaced when it comes to what happens in financial markets in practice and work against what we are hostage to: our "animal spirits". You know, fear, greed.. the usual day-to-day stuff.

Allow me to explain in more detail.

I assume that everyone in mainstream finance and government now wants to see credit markets back to normal, i.e. a resumption of borrowing and lending, a rebound in housing and retail sales, global trade. (You know, I am not crazy about this Permagrowth model, but the memo is not about me.) For "growth" to happen, credit demand is of paramount importance: people and businesses must want to borrow. It doesn't matter much if lenders are willing to lend, if there are no willing takers for their loans.

As you know, credit demand from the private sector is very low right now. Apart from the economic crisis which reduces demand, another important factor is pricing, i.e. current and future prospects for the direction of interest rates. If a potential borrower is sitting on the fence about taking out a loan, your statements about low rates as far as the eye can see are creating no sense of urgency at all.

There is plenty of time to think it over, you seem to say. Interest rates are low and will stay low, so no need to rush into a decision right away. Stick around, but you're not going to miss the boat, anyway.

How about this message, instead:

Current interest rates being near zero is an unprecedented event that will not last much longer. We are planning to raise rates in the very near future because such loose conditions are unhealthy for monetary stability and the economy in general. So, if you want to borrow, the best time is right now.

In other words, you should immediately start dispelling interest rate complacency.

Sincerely Yours.

Comments

[DWStein:]

A very interesting point…

If I’m reading you correctly, your point is that the Fed is giving the wrong price signal to the borrowers of the world. The un-intended consequence, you’re saying, of recent Fed statements is a price signal that provides an incentive to delay borrowing. This, in turn, contributes to continued low credit demand.

It’s an interesting notion, but I don’t think credit demand is in the driver’s seat. Credit availability may be the sine qua non of solid economic growth, but I don’t think it’s the cause.

Asset purchases may be delayed due to price decrease expectations. And, they may be delayed due to lack of credit. If, however, players expect prices to decrease, credit price expectations are not going to help. In fact, if buyers think rates are going to rise ‘pre-maturely’, the buyers might conclude economic conditions will deteriorate further. It’s a less elegant description of a liquidity trap.

Lastly, the yield curve has been upward sloping for some time now. The market is telling us that rates are going higher in the future. So, at least some players out there think the Fed is, in fact, going to raise rates before long. i.e. the market is digesting far more than what is said in a given Fed missive.

All of these issues are the un-intended consequences of a central planned monetary system. I’m not saying we should get rid of the Fed, but part of the cost associated with their existence is this sort guesswork. And, before we get all fired up at them for moving too fast or too slow, consider what life might be like without them.

Jul 05 01:17 PM

[Mad Hedge F...:]

This divergence is setting up a nice trade. The stage is now set for the dollar. With the US 20 months into a recession, it’s just a matter of time before the Fed pull us back from zero interest rates. With the ECB late to the funeral, European Central Bank president, Jean-Claude Trichet, last week reaffirmed his commitment to keep their benchmark rate at 1% to restore the economy. There’s your trade. The next move in the euro/dollar spread will be in favor of the greenback, as the US will be the first out of recession. On top of that, you can pile a fading US stock market and a back off in commodity prices, which are also dollar positive. Thus, you can expect the euro to trade down to the low $1.30s. Mind you, this is still a counter trend trade, which I generally try to avoid. Anyone reading the National Enquirer knows the dollar is going down long term, and even my cleaning lady has a major position in the futures. Thus, the street is overdue for a spanking, the inevitable outcome when there are too many one way bets. I still think it will cost two Euros to buy a buck sometime in the foreseeable future. For those hardy souls willing to scoop up some pennies in front of a steam roller, look at the 200% short euro ETF (DRR), which has backed off 34% from $63 to $42 since November.

Jul 05 05:17 PM

[TradingHelp...:]

I agree that rates will have to rise in both the US and Euro-Zone, but not yet.

If data improves, particularly US unemployment figures, you could argue a case for it, but rate rises anytime soon under the current flow of news, would kill the recovery before it even got into its stride.

Jul 05 05:43 PM

[DWStein:]

I think the technical situation confirms your fundamental view on EUR/USD. From the highs (using Elliot Wave) I see the corrective A and B leg with C on the way. Given how slow the ECB has been and Europe's overall lack of dynamism, EUR/USD could trade back towards par....


On Jul 05 05:17 PM Mad Hedge Fund Trader wrote:

> This divergence is setting up a nice trade. The stage is now set
> for the dollar. With the US 20 months into a recession, it’s just
> a matter of time before the Fed pull us back from zero interest rates.
> With the ECB late to the funeral, European Central Bank president,
> Jean-Claude Trichet, last week reaffirmed his commitment to keep
> their benchmark rate at 1% to restore the economy. There’s your trade.
> The next move in the euro/dollar spread will be in favor of the greenback,
> as the US will be the first out of recession. On top of that, you
> can pile a fading US stock market and a back off in commodity prices,
> which are also dollar positive. Thus, you can expect the euro to
> trade down to the low $1.30s. Mind you, this is still a counter trend
> trade, which I generally try to avoid. Anyone reading the National
> Enquirer knows the dollar is going down long term, and even my cleaning
> lady has a major position in the futures. Thus, the street is overdue
> for a spanking, the inevitable outcome when there are too many one
> way bets. I still think it will cost two Euros to buy a buck sometime
> in the foreseeable future. For those hardy souls willing to scoop
> up some pennies in front of a steam roller, look at the 200% short
> euro ETF (seekingalpha.com/symbo...), which has backed off
> 34% from $63 to $42 since November.

Jul 05 07:27 PM