Monetary Policy And Financial Imbalances: Is Transparency Virtuous?

In Saturday's Wall Street Journal, Sebastian Mallaby has authored an intriguing article entitled: "The Fed Should Surprise Us." The thesis of the article is that Fed "transparency is not always virtuous." He argues that by being less transparent, the Fed "could discourage traders from taking on too much risk."

According to Mallaby, central bank transparency works until it does not. He cites the 1999 and mid-2000s as periods during which transparency "appeared" to be working. Flash forward a couple of years and that view had been OBE (overwhelmed by events).

Mallaby notes that the Fed learned the 1970s lesson but not the lesson of 2008. It will hike inflation and destroy jobs when inflation threatens. However, when other imbalances such as excessive credit creation and overvalued asset prices percolate, the Fed fails to take action. Interestingly, these positions become self fulfilling - as Mallaby states, "the calmer markets remain, the better central bankers feel."

It is hard to disagree with Mallaby. We recall the Fed's conference in Jackson Hole, Wyoming, in August 2005, at which Alan Greenspan (at the time nearing retirement) was "annointed" the "greatest" Fed chairman ever. Not four years later, in the midst of the global financial crisis, he sat in the hot seat before Congress and humbly admitted that his "ideology" had "failed." The hero at the 2005 Conference, it turns out, was Raghuram Rajan, who had the audacity to present a paper entitled: "Has Financial Development Made the World Riskier?" He concluded (correctly, in our view at the time) that it had. He later reflected that he felt "like an early Christian who had wandered into a convention of half-starved lions."

So what is the Fed to do? We agree that the Fed should act less predictably. Maintaining its current stance permits market participants opportunity to "game" the central bank. For example, as the Fed began to tighten the fed funds rate from 1% in 2004, it pre-announced rate hikes. Investors were understandably enthralled. Positions were built based on that continued trajectory. Today, as Mallaby notes, the situation is even more pronounced, given algorithmic trading, selling volatility, etc.

Complacency reigns supreme today! These positions become self- fulfilling - belief that markets will remain calm generates positions that result in markets that are calm... until they are not (2000 and 2007-8)!

What tends to follow these periods of market complacency can quickly become very ugly. There is much to be said for the Fed abandoning transparency and "acting less predictably." The alternative (e.g. "continued transparency") is for these positions (e.g., selling volatility, etc.) to continue to accumulate in an environment of generalized complacency, ultimately triggering a massive unwind when the crisis inevitably arrives.

Conclusion

One caveat we would add to Mallaby's argument is the sizable private sector debt ratio that presently exists. Despite the crisis, private sector leverage remains high (at about 150% of GDP versus 170% in 2008). If the Fed becomes less transparent at this point in time and unexpectedly raises rates, the impact could be quite significant, given risks of deleveraging and balance-sheet recession. However, a return to a more "ambivalent" posture by the central bank makes very good sense.

It is difficult to forecast market complacency or how long today's "complacent" environment might persist. Given current asset class valuations (expensive virtually across-the-board, with the exception, perhaps of non-US equities), we currently hold a 16% cash position in our multi- asset class portfolio. With that said, our current Market State currently reveals few signs of market turbulence. The reality is that market sentiment can turn on a dime, so we intend to be prepared. We are willing to sacrifice modest upside for capital preservation in the current environment.