This Is the End


Markets, Risk and Human Interaction

October 25, 2007

What if there comes a time when the Fed has to tighten?

It might seem now that it was in a different world, but it was in this one, and in fact it was in the United States. Traders watched their bank of broker screens as the 30-year Treasury dropped below 8% for the first time in their youthful memory. That was in the 1980s. I was working at Morgan Stanley at the time, and someone on the Treasury desk made a trade for his own account just so he could frame the ticket from that momentous event. Yes, interest rates can go above 8%. In fact, at the time an 8% rate seemed quite reasonable.

I mention this because over the past decade or so we have constructed a financial landscape where an 8% interest rate not only is hard for us to envision, but where it would be disastrous. The reason is the huge stock of adjustable rate mortgages. Looking at the dislocations that are coming about from the subprime problems and the related credit crunch, it is hard to fathom the effect on the housing market and the overall economy if all those remaining homeowners with various flavors of adjustable rate mortgages saw rates shoot up hundreds of basis points. I don’t know how to quantify the effect, but I would hope that there are researchers at the Fed who do. And I would bet that the implications are pretty scary. Maybe so scary that the Fed would not be able to push interest rates up very far for fear of triggering a populist revolt.

Of course, now all of the discussion is about possible Fed easing. So I am worrying about something that is not even on the radar screen. But can anyone envision a scenario where a substantial increase in interest rates would make sense from an economic standpoint, but where the Fed finds its hands tied because the costs to homeowners would be too great?