The Strategy of Surprise: Will the Fed Cut the Rate Next Week?

The hot topic in the investing world is whether the Fed will cut the federal funds rate next week. The word on the street is yes, it is basically certain:

Federal funds futures show traders see a 100 percent chance of a reduction in the benchmark rate [in December], with a 30 percent probability of a half-point move.

from Bloomberg

It would make sense if the 100 percent meant the rate cut is a sure thing. But in the weird world of economics, it does not. It is more of a strong indication based on available data—like how a 41 point spread does not mean a team is sure to win.

In other words, do not be surprised if the Fed leaves the rate the same and the market is surprised. The Fed has worked by surprise before.

On the surface, the Fed process seems unnecessarily complicated. The Fed could just tell the public what it intends to do. It could reveal its methods and divulge its models—just as weather stations give you access to their Doppler radar.

But instead we have to analyze cryptic press releases. Here’s what Chairman Ben Bernake said about the decision to cut rates:

In making its policy decision, the committee will have to judge whether the outlook for the economy or the balance of risks has shifted materially. In so doing, we will take full account of the implications for the outlook of both the incoming economic data and the ongoing developments in the financial markets.

Say what? Could you be any less precise?

I joke because there are financial soothsayers who claim to understand what these statements mean. Like a psychic predicting your day from flipping two taro cards, these analysts combine Fed statements with their own perceptions about things like the Libor to predict what the Fed might do. Hey, it at least makes for an interesting read.

Don’t bother with learning how to translate Fedspeak. It seems the Fed is intentionally vague, and that there is an underlying method to their seeming madness. And that’s because the Fed uses game theory, naturally.

Before I discuss the game the Fed plays with investors, I will briefly provide some context about the fed funds rate and why it is important.

A Primer on the Fed Funds Rate

The Federal Reserve System (the “Fed”) is the central banking system in the U.S. established in 1913. The Fed’s most important role is regulating the nation’s monetary policy, which encompasses controlling inflation and promoting stable economic growth.

The Fed is so powerful that it can indirectly control interest rates for the whole economy. The Fed can adjust the federal funds rate, which is the overnight interest rate that banks borrow from each other. The federal funds rate is important because other interest rates are essentially pegged to it. When the federal funds rate is cut by 0.5%, banks react by lowering their savings and CD rates by a proportional amount. This is why people saw their online savings account rates dip recently.

By influencing interest rates, the Fed can essentially regulate the economy’s growth. Lower interest rates mean that companies can borrow money easier and invest more projects, jumpstarting economic expansion. Conversely, higher interest rates curb investments and growth.

One might naively think lower rates are better since they promote growth. But this is unfortunately not the case because overinvestment and growing too quickly cause inflation. So the Fed has to figure out how to stimulate the economy without causing it to overheat with inflation.

Finding the proper balance is tricky, to put it lightly.

Fool Me Once

The Fed likely wants to keep us off balance when it makes a decision on changing the rate.

And that’s because of the theory of rational expectations, accidentally summarized by George W. Bush: “Fool me once, shame on – shame on you. Fool me — you can’t get fooled again.”

The theory implies that repeated actions lose their effect. Other players realize predictable actions and counter. That is, people change their expectations.

The Game with Investors

Right now, many economists would say America is suffering from the failure of many sub-prime mortgages. Banks gambled too heavily on risky investments that turned sour, which is now preventing good investments from taking place.

To stimulate the sluggish economy, the Fed would naturally cut rates.

But does the Fed always bail out investors?

Absolutely not.

If the Fed always bailed out risky investors, then investors would be encouraged to make bad decisions again (a problem called “moral hazard”). It’s kind of like how parents have to carry out discipline even if they think the child has learned the lesson.

The Fed needs to discipline investors but without harming the economy at the same time. The Fed accomplishes this by keeping investors off-guard and occasionally acting through surprises. If investors cannot rely on a bailout, they will be encouraged to consider risks more carefully.

And this is why a 100 percent prediction is not always a sure thing.

So don’t be surprised when you read Fed members waffling so close to decision-time, as evidenced by this statement last week:

Overall, Stern said he expects the economy to be weak this quarter and to begin to get stronger in the first part of 2008. That’s not a forecast suggesting he thinks a rate cut is urgently needed.

“I’ve not made up my mind what to do yet,” said Stern, one of the members of the FOMC. “Why would I? There’s two weeks to go. We’ll see what we learn.”

from Bloomberg

Not made up his mind yet?

As a game theorist, I doubt that real-time forecasts and are the only reason for his delay.

He just wants to keep us investors in suspense.