"We should all hope for a normalization of interest rates - that's a good thing," Dimon of JPMorgan Chase (JMP) said today during a panel discussion at the Fortune Global Forum in Chengdu, China. "As we go back to normal, it's going to be scary, and it's going to be kind of volatile." This from Bloomberg.
Fed listeners have gotten jumpy over the past month. These listeners have heard talk that the Fed might slow down its purchase of bonds.
The implication of a slowdown in Fed bond purchases is that interest rates will rise.
And the rise will bring interest rates back into a more "normal" range ... whatever that might be.
What Dimon adds to this is also interesting: "Global markets will face increased volatility as central banks bring interest rates back to normal levels."
Why might the financial markets be more volatile and why might this be "scary?"
I believe that the financial markets will be more volatile as the central banks allow interest rates to move back up and, hence, more "scary" because this will be a "new" world. A "new" world in the sense that participants in these financial markets will not know what the rules applying to these markets will be.
In the forty years or so leading up to 2007, there were understandings between the Federal Reserve and participants in the money markets. The Federal Reserve acted in certain ways, provided certain signals, and the money markets generally knew what to expect and how to behave. Yes, there were times when the Fed moved in ways that market participants felt were "surprises" but there were not many of these times and the Fed then always reverted to the "expected" behavior that had existed in the past.
Financial market participants understood the rules of Federal Reserve actions although they did not know when or how the Fed would implement its monetary policy.
For financial market participants, the future was risky but not uncertain. Here I am using the distinction established by the economist Frank Knight where he described risk as pertaining to situations where the outcomes were not known with certainty but could be viewed in terms of a probability distribution. Uncertain situations were ones where the outcomes were not known with certainty, but there was no idea what the probability distribution of these outcomes might be.
Over the past four years and almost nine months, there have been no rules for the conduct of monetary policy. On September 15, 2008, Lehman Brothers declared bankruptcy. Soon after, "Federal Reserve Chairman Ben Bernanke reached the end of his rope on Wednesday afternoon, September 17." (This quote is taken from the Wall Street Journal and was used in my post "The Bailout Plan: Did Bernanke Panic.")
Since then, Chairman Bernanke and the Federal Reserve System have been flying blind. Mr. Bernanke and the Fed have had just one objective in mind since this time…to avoid an economic collapse as bad as the Great Depression. I have described the monetary policy followed by the Federal Reserve since this time as one in which the Fed threw everything it could against the wall to see what might stick and prevent another Great Depression.
In this they have succeeded. A Great Depression…at least up to this time…has been avoided.
In order to signal to the financial markets that the central bank was going to continue throwing all the "stuff" it could against the wall the Federal Reserve explicitly "announced" its bond buying programs…Quantitative Easing One, Quantitative Easing Two, and Quantitative Easing Three…and it posted projections of the target range it was using for the Federal Funds rate. Projections for this target range were extended out for one to two years.
In doing this, Mr. Bernanke wanted to make sure that the financial markets understood what the Fed was going to do…and that the Fed seriously meant to carry out these actions so that participants in the financial markets should believe it when the Fed said that it was going to do just what it said it was going to do.
So, these have been the ground rules for monetary policy over the past few years. Mr. Bernanke and the Federal Reserve had to be so explicit about the rules and also had to be so emphatic about them because they were something that had never been seen before in all central banking history. Mr. Bernanke was basically saying…this is what we are going to do and you had better believe that we are going to do it.
Now, we are in new territory. There are no established rules for the conduct of monetary policy at this time. The Federal Reserve has increased the size of its balance sheet by about $2.5 trillion since August of 2008.
One would think that the Federal Reserve is going to shrink its balance sheet, once it believes that the economy is growing normally again. But, will the Fed shrink its balance sheet? And, if it does how is the Federal Reserve going to shrink its balance sheet? What are the new "rules of the game?" How should participants in the financial markets behave under these circumstances?
And what is this future economic setting really going to look like? Will there be a pick up in inflation? How fast will interest rates move up? What will the movement in interest rates look like? How far will interest rates rise during this time that the Fed is withdrawing reserves from the banking system? What will be a "new normal" range for interest rates in such a scenario?
Furthermore, when the "new normal" range of interest rates is achieved, what will be the new operating guidelines for monetary policy, the new rules for financial markets?
This will be a scary time for financial institutions. There will be greater financial market volatility.
In the period from the late 1950s up until the fall of 2008, the Federal Reserve adopted some fairly standard operating procedures. Stability of the financial markets was always a major goal of the Federal Reserve in its conduct of monetary policy.
Will this be something that the Federal Reserve attempts to restore after the "new normal" range of interest rates is achieved?
My guess is that to achieve this "new normal" a period of two or three years will pass. The Fed will then need to "teach" a whole new generation of traders the new rules of the game. In fact, a whole new generation of central bankers will need to learn how to establish the new rules of the game.
As Mr. Dimon has stated…this will be a volatile…and scary…time.
And, how is Mr. Dimon going to try and get through this period? "I am going to be looking at every word the Fed says."