Thursday, April 29, 2004

Market mechanisms of risk discounting - Federal Reserve and interest rates

Brad Delong features an essay about the nature of the ability of the Federal Reserve to act as a market-mover on declarations alone.

However the essay is incorrect when it posits that there is no market mechanism that is creating this response.

It's a meta-credit effect, the credit of credit. If the effective 'credit rating' of a lending institution is high enough - a measurement of its liquidity and price to book value which is a rating of the credit worthiness of its financial evaluations and loans - then it would be natural for a market mechanism to grant a very high meta-credit rating a very high discount.

In the limit where the meta-credit rating approaches a very large ratio to the asset / liquidity ratios of lending institutions and market mover purchasers then you have an approach to an almost complete risk discount - e.g. the most powerful and stable central bank in the world.

In that scenario, the market is going to be moved entirely by the expectation of the cash and capital flows of that market dominant institution. Hence the saying, "don't fight the Fed." Were that expectation of absolute correlations to weaken, uncertainty to increase, and therefore effective risk in trusting in the Federal Reserves pronouncements to increase then the market discount would be erased and you would have to see substantial market movement from Fed intervention in order to see a subsequent yield curve capitulation.

It's really about risk discounts in credit worthiness evaluation. If people believe that you will follow through on your word, no matter what, your word becomes a source of credit itself and can exert financial leverage in any given market situation.

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