Risk is defined in terms of market volatility. Anything that might cause the market price of an asset to vary over time is identified as a component of the riskiness of that asset. Thus we have credit risk, interest rate risk, and country risk, to just name three possible sources of risk.
I would like to add another source of risk to the list, a source that has grown in importance over the past several years: central bank risk.
We have seen central bank risk in operation over the past several months. It has to do with the decision of whether or not the Federal Reserve should "taper" its purchases of securities from the $85 billion per month schedule it is now acquiring. The Board of Governors of the Federal Reserve System made the decision to engage in a third round of quantitative easing to help stimulate the United States economy into a range of faster growth and lower unemployment.
One of the targets set by the Board was to reduce the amount of unemployment in the economy to 6.5 percent as long as the rate of inflation doesn't exceed 2.5 percent. In September the unemployment rate was 7.2 percent and the rate of inflation, as measured by the consumer price index, was 1.2 percent, also for September, measured year-over-year.
But, saying that you are going to buy $85 billion in securities every month sets up market expectations. Initial talk about the possibility of slowing down the quantity of purchases brought out a difference between how members of the Fed viewed this "slowing down" and how market participants viewed this "slowing down."
Defenders of the policy stated that the situation was like someone driving a car. If you are going 85 miles an hour and ease up on the pressure that your foot is applying to the gas pedal so that you are going 70 miles per hour doesn't really change things because the car is still moving at a very rapid pace. The difference is just between going "fast" and going "faster."
Participants in the bond market said that this analogy did not work. They argued that if you are going 85 miles per hour and the market is following close behind you in another car, slowing down to 70 miles per hour could cause a pretty serious accident.
In other words, if I am making market bets based on the Fed injecting $85 billion of cash into the bond markets every month and the Fed reduces the amount of cash it puts into the bond market every month, this represents a pretty serious tightening of monetary injection … with emphasis on the term "tightening."
So, we see over the last several months the volatility that interpretations of what the Fed will do with respect to purchasing securities and when it will do it has increased substantially.
On May 22, Chairman Bernanke spoke to Congress. He introduced the idea of the Fed "tapering" its purchases of securities. He did not say when this might occur, but the consensus of the market soon began to focus on the September meeting of the Board of Governors.
The yield on the 10-year Treasury bond was around 2.00 percent when he spoke. A month later, the yield on the bond rose to more than 2.50 percent. The rate was around 3.00 percent in early September.
The Board of Governors met on September 17 and 18. The Board decided not to "taper." The economic data were just not strong enough and there was the possibility of a government shutdown. Bond prices immediately shot up. The yield on the 10-year Treasury bond dropped from about 2.85 percent to around 2.50 percent a month later. The market consensus moved the date of "tapering" off until possibly March 2014.
But, the yield started to rise again last Friday on news that the economy was stronger than it seemed to be in the middle of September. On Tuesday, we read that the market responded to the latest information from the Institute for Supply Management (ISM) that the economy seems to have been minimally affected by the government shutdown and debt-ceiling debate.
Bond prices fell and the yield went to 2.67 percent. The interpretation: if the economy is "on track" then the Fed will begin to "taper" sooner than March 2014. This is negative for bond prices.
This is central bank risk. How the Federal Reserve is operating is creating volatility in bond prices. And, it has be operating in this way for several years.
Mr. Bernanke has, almost from the beginning of his tenure as Chair, has tried … in his way … to provide clearness and transparency of what the Federal Reserve is doing. At times, he almost seems desperate in his attempt to provide clarity. (See my post "Ben Bernanke: Please Understand Me.") At times he almost seems to cry out for people to see things his way.
There are several problems with this. First, there is the problem of forecasting. The Federal Reserve is not much better than anyone else when it comes to forecasting the future and the consequences of economic policy. Over the past 10 to 15 years the Fed's record has be abysmal.
Just check out what Alan Greenspan, former Chairman of the Board of Governors, has to say in his new book "The Map and the Territory: Risk, Human Nature, and the Future of Forecasting" (Penguin Press HC, October 22, 2014). My major assumption about forecasts … all forecasts … is that "forecasts are wrong."
But, to put the Federal Reserve on the line raises the attention to another level. The Federal Reserve forecast means that the Federal Reserve is making policy on the bases of their forecasts and their belief in how their policy decisions are going to impact future outcomes. Now, they are providing "forward guidance" on these forecasts.
This makes these forecast very important. We concentrate on what the Federal Reserve believes it is doing. Therefore, when the Fed comes out and changes the policy they have so boldly announced in the past several things pass before our minds.
First, what has changed? The Fed was wrong by why and by how much? Second, what is the Fed now going to do? And, third, how long will the new forecast last and when will we be subjects to further changes in outlook. And, as we have seen over the last six months or so, the market reactions can be fairly substantial. And, market adjustments tend to be in discrete jumps and are not achieved incrementally.
This is something the Fed tried to avoid at all costs at an earlier time. Now we see that a Federal Reserve study is going to be released that supports the particular policy behavior that the Fed has been following for the last four years. Jon Hilsenrath, in the Wall Street Journal, discusses this new research that claims that not only should the Federal Reserve continue to keep its target interest rate low, but it should also lower the target unemployment rate from the current level of 6.5 percent to something as low as 5.5 percent.
Hilsenrath writes that Federal Reserve officials "want investors to believe interest rates will stay low even as the economy strengthens and as the Fed winds down its $85 billion-a-month bond-buying program." Here we have "forward guidance" again. It must be said that some Fed officials have doubts about the reliability of these forecasts because "of the kind of computer forecasting models used in the studies." But, the real problem, to me, is that the computer models don't pick up some of the changes that have taken place in the economy.
For example, do the models pick up the fact that the low interest rates and the slack household demand for residential real estate have resulted in hedge funds and private equity funds purchasing these properties and then renting them to households? Do the computer models show how one of these funds is packaging these rental units into anew securitized asset class and then selling them off into the market? Do these computer models show how the construction industry is changing because of the low output of the industry and the fact that quite a few, fairly large construction companies are now owned by private equity funds?
And, do these models show that much of the money the Federal Reserve has pumped into the economy though its three rounds of quantitative easing have gone into the financial sector and have supported outcomes like the ones just described and have not gone into manufacturing and production? Consequently, real economic growth seems to be achieved a "new normal" growth path of about 2 percent.
For the Federal Reserve to continue to follow the trajectory it is on and to be producing research to justify this trajectory is just calling for more of the same. Fifty years of credit inflation has taught savvy investors to look for the opportunities created by the credit inflation.
This is where the returns are, not in investing in the real production of goods and services. Furthermore, by causing market participants to focus on what it is doing rather than focus on producing goods and services the Fed has created greater volatility in the financial markets. The economy and the financial markets work best when no one really cares about what the Fed is doing. When we focus on the Fed the way we are now … we are trying to deal with central bank risk!