The Fed’s Options

RGE’s Kevin Harris has a nice preview of the July FOMC meeting: in brief, FOMC members are locked and loaded, ready for a September hike, though they will refrain from committing to a move and do their best not to cause an overreaction across the yield curve, where too few hikes are priced in relative to the FOMC “dots.”

Tim Duy’s Fed Watch concurs, and cites the WSJ’s Greg Ip in making the case that there is “an option value of hiking”! We at RGE, among others, have previously thought the Fed instead saw “an option value of waiting.” “Option value” as a monetary-policy metaphor that, to most people, references Black-Scholes pricing never made sense. There is a body of work in economics on the “option value of waiting”; that refers to a body of research on corporate investment in an environment of uncertain risk-reward.

Since hiking or not hiking doesn’t have any up-front cost, even this analogy is a poor and confusing one, at least for me, especially if there is also “an option value of hiking” as in the link above. The point is to assess trade-offs, benefits and risks of falling behind the curve a bit (less blame if there is a downturn, faster convergence to targets, wage rises and reversing hysteresis… but inflation, and needing to hike 150-250bps in a year later, normalizing faster, reaching inflation target “from above”, and as Duy emphasizes, financial instability/imbalances may increase) versus being hawkish on inflation and leaning against the wind, and getting a few hikes in early. Krugman thinks the cost-benefit balance is easily in favor of later, while the WSJ implies that Yellen’s “risk-management approach”, taking into consideration financial stability considerations (a.k.a. “leaning against the wind”) is now favoring sooner to avoid the unthinkable horror of needing to hike twice in a row someday in the future, or hiking 50bps in December, an idea that is so shocking Ip doesn’t even consider it, but it would be the obvious thing to do if, in hindsight, the Fed realized that they should have hiked in September and the right level for Fed funds going into 2016 is 50-75bps rather than 25-50bps (remember that the Fed still isn’t targeting a precise level, as that gives it more flexibility with managing the quantitieson its balance sheet).

You can never turn back time — there are risks an “early” hike being wrong, or waiting being wrong. The potential policy mistake is that slow hikes, while dampening volatility, encourage risk-taking and leverage (à la Minsky). Another is that the EM turbulence and spill-back to the US after the first couple of hikes prove Fed critic and current RBI chief Ragu Rajan was right.

Anyway, back to the language we use to describe September’s choice: Before you make a choice, you always have options. Once you act (and not hiking is still an action!) the other “option” disappears, but that is not really saying a lot: if they don’t hike in September, they “forego the option” of hiking 2-3 times; if they do hike, they “forego the option” of not hiking through year-end. Talking about cost-benefit analysis is a better framework than a muddled discussion of giving up “options” at any point in a decision tree.