The meetings of the Federal Open Market Committee (FOMC) have always attracted attention, and the upcoming gathering on September 16 and 17 is no exception. Despite the Fed’s declared commitment to transparency, the anticipated policy announcement is more uncertain than ever.
This year, the Fed hinted at a potential rise in the federal funds rate from its long-standing near-zero level. However, each FOMC meeting has seen this decision postponed. Just weeks ago, the September meeting was expected to signify a modest increase in rates.
That changed dramatically after the stock market plummeted by 12 percent. Amid the turmoil in late August, New York Federal Reserve Bank President William Dudley signaled a retreat from a September rate hike, which markets received with relief, akin to manna from heaven.
As the market stabilized, uncertainty loomed—was the rate increase still on the table? No one seems to have a clear answer, including the Fed itself.
Further delay in raising rates could severely undermine the Fed’s diminishing credibility. It appears they are improvising policy decisions rather than adhering to a steadfast plan.
A Standoff
The Fed finds itself in a precarious situation. After over six years of maintaining a zero interest rate policy and a staggering 400 percent increase in the money supply, the path to normalization appears fraught with potential for major market upheaval.
As the FOMC meeting approaches, public opinion against a rate hike is growing. The New York Times has voiced its opposition, and in a twist of irony, Larry Summers—who was once in competition for Janet Yellen’s role—has taken to the internet to offer his insights.
“Two weeks ago, I argued that a Federal Reserve decision to raise rates in September would be a serious mistake,” Summers stated on his blog. “At that time, the market assigned a 50 percent chance to a rate hike, which has now fallen to 34 percent. Based on discussions with economists, Fed governors, and bank presidents, the case against a rate hike has become even stronger.”
He details his arguments before concluding, “Now is the time for the Fed to do what is often hardest for policymakers: Stand still.”
Perhaps, but has the Fed not remained stagnant for nearly seven years already?
While we may not have the definitive answers that Summers or Yellen possess, we do not pretend to. Our perspective is that individual lenders and borrowers can determine fair interest rates much more effectively than unelected officials can.
The reality is that the Fed’s key interest rate influences trillions of dollars in significant investments, affecting not only high-risk hedge funds but also pension fund managers and even municipal treasurers.
A History of Amplified Losses
Consider the example of Robert Citron. As the treasurer for Orange County, he managed to oversee a staggering $1.64 billion loss of public funds in 1994, which led to the largest municipal bankruptcy in U.S. history. This financial disaster was triggered by the Federal Reserve’s decision to increase interest rates.
“Robert Citron was viewed as an investment prodigy,” explains Andrew Beattie from Investopedia. His investment performance consistently bested neighboring pools by 2 percent, attracting a steady stream of investors from schools, cities, and districts who largely overlooked the risks involved.
“In essence, Citron bet on persistently low interest rates. He exploited the difference between short and long-term yield as an opportunity for arbitrage using structured notes. Although this strategy came with heightened risk, it was workable, at least initially. Citron excessively leveraged his portfolio to amplify profits, which became a major issue.”
“Through a series of reverse repurchase agreements, he used his securities as collateral to secure more loans for additional securities, inflating his $7 billion portfolio into a $20 billion position. This aggressive leveraging magnified his gains until the Fed initiated rate increases in February 1994, turning those amplified gains into significant losses. Ultimately, the county couldn’t sustain the losses and declared bankruptcy.”
The timing of the next Fed rate increase remains uncertain, but it’s inevitable that when rates do rise, substantial bets may turn sour. The sporadic guidance from the Fed has heightened the likelihood of financial crises occurring.
Reflecting on the Orange County fiasco, a grand jury investigation revealed that Citron had relied on a mail-order astrologer for interest rate forecasts.
Perhaps Yellen does too.
Sincerely,
MN Gordon
for Economic Prism
