The Fed’s non-tightening tightening

Let’s see. The Fed hiked a rate even though it wasn’t the policy rate. The Fed shortened a term even though it wasn’t the “normal” term. The Fed announced it as a surprise even though they have been saying they want to be transparent and prepare markets for changes in advance. And the Fed speakers then spent effort trying to explain why a discount rate hike at an inter-meeting move with a reduction in term is not a tightening action.

By using this surprise the Fed has introduced some confusion into markets. It doesn’t mean rates are going up tomorrow or next month or by mid-summer. But it does mean that an additional uncertainty has been introduced into market pricing. Interest rates will now reflect this uncertainty. The dollar strengthened immediately as one would expect it to do. Currency exchange rates are now the first thing to react to changes in policy. And this was a change in policy event though the Fed says it is not so.

Does this action mean that tightening actions are limited only to actions taken by the whole FOMC and not actions taken by the Board of Governors? Is that only true for tightening actions but not true for easing actions? Is policy applied asymmetrically? Do we have a central bank that lowers rates in emergencies with inter-meeting moves and calls that easing but changes and raises rates in inter-meeting moves and calls that something other than tightening? This action adds to the questions because of the way it was done.

Why surprise the markets? That is the one element which has not been explained.

If you do surprise the markets, then why go to great lengths to explain that you are not tightening and that the policy is the same as it was before the announcement. If it was the same as before the announcement, why make the announcement and why make the changes.

It certainly is not the same. Markets know it. The currency exchange rates know it. The Fed knows it. Something happened. Things are different.

We still do not expect the Fed to hike the Fed Funds rate significantly before the end of 2010. We still believe that the world’s short term interest rates will be between zero and 1% for all for this year and well into next year. We still think that monetary policy must favor an extended period of ease.

But the Fed has now added an uncertainty premium and markets are adjusting to it. That means somewhere, some mortgage will not get refinanced. And somewhere, some bond financing will cost more to accomplish. And somewhere, some US manufacturer who exports will face a headwind because the dollar is stronger and his foreign competitor can sell more cheaply than yesterday. And somewhere, some person is not going to get hired because this uncertainty has raised the risk of hiring to the employer.

That, friends, is a tightening.

David R. Kotok, Chairman and Chief Investment Officer
February 19, 2010

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