I am old enough to remember when stocks used to trade in eighths. I know this might seem crazy to my young readers, but almost everything used to trade in fractions of eight. When you wanted to narrow the spread, we moved down to sixteenths and thirty-seconds. It sometimes even got really stupid and we would trade stocks in 128ths. Obviously this tradition was nothing more than an archaic throwback to the past, and the equity markets had the good sense to move to decimal trading well over a decade ago.
The US bond market is one of the last refuges of fractional pricing. And this convention also applies to the Federal Reserve. They have traditionally set the Fed Funds rate in quarter point increments. But there is no reason why they can’t discard this ancient practice.
Reflecting on the problems that Yellen & Co. face regarding their guiding the US economy onto a tightening path, I realized this would be a perfect opportunity to ditch the tradition of Fed Funds being set in quarter point increments, and instead move to decimal pricing.
The Fed desperately wants to avoid the problem of the market assuming more tightening than the economy can handle. There has been repeated assurances from FOMC members that once the tightening starts, it does not necessarily mean that rates will increase 25 basis points every meeting like the previous tightening cycle.
One obvious solution to this concern would be to change the increments. If they increased by ten basis points as opposed to quarters, it could dramatically change the market’s expectation future rate increases. Even if they raised at every meeting, but only did it in 10 basis point chunks, the rate rise would be significantly smaller.
And if you think about it, a move to more granular changes makes sense. When Fed Funds were 5% or 6%, quarter point movements were appropriate. But now that interest rates throughout the world are all minuscule levels, moving in such large hops makes little sense. A move from 5% to 5.25% is a lot different than a move from 0.25% to 0.50%.
Changing from fractional quarter point moves to decimals might be a perfect solution to many of their problems. The FOMC committee could raise rates to satisfy the hawks, but at the same time limit the actual raise by moving in ten basis point increases. They could even raise rates every meeting and have a much smaller effect on the economy.
It would be a win-win for everyone. The hawks would get their raises, and the doves would be comforted by the fact that the increases were small. At the same time, moving to decimals wouldn’t limit the potential for future hikes of equal magnitude as previous quarter point moves. It really is a can’t lose solution.
I am on the record as saying that the first tightening won’t be until December. But I am going to make a caveat to that prediction. If we are going to get an increase in June or September, it will be only 10 basis points.