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12 05 2015 | by Victor Xing | Economics

What are possible effects of market based interest rates?

If the Federal Reserve does decide that abandoning its monetary policy control and letting market conditions set interest rates (market based interest rates) would be the best way to achieve its dual mandate, then quite a few things can happen:
  1. Excessive risk-taking would diminish.  The Federal Reserve reduced volatility and induced market conditions that pushed otherwise prudent investors into riskier assets.  Without an implicit backstop, market based interest rates would force many investors to rethink market risk and position accordingly
  2. Credit cycles will be replaced by bouts of small credit condition tightening and loosening.  Cash holders will be at a significant advantage with the lender of last resort out of the picture.  Under adverse funding conditions, the person who stuffed mattress with cash would become king.
  3. An entire generation of investors and market participants will have to relearn front-end bond valuation – without central bank rate path expectations, front-end of the curve will lose a significant driver for valuation, but the Treasury curve would then truly reflect market based funding cost, thus giving investors better signal on economic conditions
  4. Currency market will undergo a system shock.  EURUSD is currently being driven by FED and ECB policy expectations, but with the FED on “spectator mode,” EURUSD would be based on expectations of ECB and U.S. economic conditions, EURUSD will likely decline notably.  Similar re-pricing will happen to any dollar curency pairs.
  5. People like me (who focused heavily on FED policy) will retool to finally provide some useful contributions to society!  This is actually a favorite topic between me and an investor whom I respect.  He would make fun of me saying that: can you imagine how many people are tied up analyzing FED policy and reading tea-leaves?  Freeing these resources and letting them take part in other economic activities would probably be a value add to the economy.  I do not disagree with him
  6. Economists will benefit from a lack of central monetary policy control.  Many companies would then have to rely on their own economic analysis (rather than FED’s analysis), because market based interest rates are more responsive to changing economic conditions
  7. Ludwig von Mises and Friedrich Hayek will likely rest easier in their graves
Ludwig von Mises – please visit his work at the Mises Institute
Advocate of market based interest rates
Original Quora article

Next article12 04 2015 | by Victor Xing | Economics

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