Are Investment Bankers Underpricing the Risk of Central Bankers Raising Rates Quickly?

Central bankers have the option of increasing rates quickly.  They also have the option of taking a plodding approach. Although central bankers could, in theory, increase interest rates just as easily by 200 basis points as they could 25 basis points, investment bankers appear convinced that the latter will be the case for the foreseeable future.

Are investment bankers right?  Could investment bankers be underpricing the risk of central bankers increasing interest rates quickly, beyond just simple baby steps of 25 basis points at a time? Here’s why most investment bankers think the Federal Reserve (and other central bankers) will be slow to increase the target interest rates they control. The graphic below depicts the tightening cycles of the Federal Reserve over the previous 40 years.

(As a note of explanation, the vertical axis is the percentage change in the effective federal funds rate from the beginning of the respective tightening cycle.  Each line on the graph represents a tightening cycle, with the label for each line representing the year in which the tightening cycle started.  The horizontal axis represents the number of days a given tightening cycle has lasted.)

fed tightening cycles

For illustration purposes, take 2004 as an example.  Mr. Greenspan’s Federal Reserve started raising rates in May 2004.  The rate increased from 1 percent to about 5.25 percent over the course of the tightening cycle.  The cycle lasted almost 1,200 days – about three and a quarter years.  As evidenced by the housing market bust, the Fed, under the leadership of Mr. Greenspan, was quite slow at increasing the interest rates, taking almost 800 days to increase the rate from 1 percent to 5 percent and doing nothing for the next 400 days.  The story of an increasingly cautious Fed is readily apparent.  Essentially, with every new cycle over the past 20 years, the Fed has become less “tight”, with a gradual shift downward in the strength of the given cycle.

Does It Matter That the Federal Reserve Has Become More Timid?

In addition to risk taking that otherwise would not have taken place, a more timid Fed has created, in the minds of investors, the expectation that the U.S. central bank will be slow to increase rates. Are investment bankers underpricing the risk that Ms. Yellen’s Fed will be bold and ahead of the curve?  The simple answer is probably not. Even Federal Reserve members’ own expectations are incredibly cautious, with, at the high end, some members putting the federal funds target rate at 2 percent in two years from now.  That’s 2 years and only 2 percent!

A cautious Fed, of course, has not always been the case.  For instance, a bold Mr. Volker quickly increased rates during the hyperinflation years of the early 80s.  But there are no Mr. Volkers at the Fed right now.

Overall, investment bankers, and even the Fed members themselves, have forgotten that the federal funds rate could go from 0.25 percent to 2 percent overnight, rather than take two years to get there.  Although investment bankers may not have underpriced the chance of the federal funds target rate increasing quickly (since it’s basically zero), perhaps the Fed hasn’t forgotten it’s ability to be courageous in the face of unwarranted risk taking.

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