Wednesday, December 12, 2012

How Will the Fed Deal With Speculation on the Fed?

The Federal Reserve's historic announcement today of specific benchmarks for changes in monetary policy--no positive short term interest rates permitted until unemployment is 6.5% or lower, or inflation exceeds 2.5%--got a resounding shrug from the stock market, which closed flat.  Or maybe it wasn't a shrug, but puzzlement.  This policy takes the Fed into uncharted territory, and the truth is no one really knows what will happen next. 

One thing that's certain, though, is financial speculators just got another trading opportunity. With the Fed specifying benchmarks, speculators can concentrate bets on which way economic statistics will go.  For example, if you think unemployment will drop quickly, short sell the long end of the Treasury securities market.  Or buy a derivatives contract over the counter to quietly do the same thing without the regulators having much idea of what you're up to. 

Because of the Fed's unquestioned ability to move the financial markets, these benchmark bets may be very large.  Indeed, as the Fed's balance sheet balloons even more above its current $3 trillion level in its relentless prosecution of QE ad infinitum, its potential impact on the financial markets will billow proportionately.  Speculators may pile on the risk in the hope of getting even more bang for the leveraged buck. 

With prospects for "real" investments like stocks and bonds murky and guarded, hedge funds and other money managers may be tempted to make benchmark bets instead of living with the disappointing returns available from the real world.  After all, they need to beat the averages in order to attract investors, and benchmark betting could offer a lucrative way to do that (if you guess right).  The financial contracts for making such a bet are manifold, so the quantity of betting may be unlimited.  Since much of this betting could take place in the over-the-counter derivatives markets, central banks and other regulators might not have a good idea how much gambling is going on.  The specter of systemic risk could lurk. 

If benchmark betting becomes a popular play, the Fed might be confronted with the problem of collateral damage to the financial system and economy if economic statistics move in unexpected ways.  If important players in the financial markets suffer a lot of collateral damage from speculative wounds, the Fed might have to deviate from its expected course of action (such as by not raising interest rates or working down its balance sheet even though unemployment drops below the 6.5% benchmark).  In such an instance, the very policy that the Fed is attempting to implement could be undermined. 

But there is no practical way for the Fed to prevent benchmark betting.  Even if it can control the risks taken by the largest money center banks (and that's no certainty by a long shot--witness J.P. Morgan's London Whale debacle), it can't control the risks that myriad hedge funds and other investment vehicles, many of which would be in other countries, might take.  If a lot of these speculators are leaning right when the economic statistics move left, the Fed and other central banks might have a highly problematic problem. 

The idea behind the Fed's announcement of benchmarks is to make monetary policy more transparent and understandable.  That's nice theory.  But the abundance of wise guy speculators in the financial markets can muck up (that's the polite phraseology) the works. 

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