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April 13, 2004

Lawn Darts
by John Mackenzie

"Let me begin with the question of whether interest rates and asset prices have been pushed away from appropriate levels. Some observers worry that recent Federal Reserve policy, by keeping short-term rates at very low levels for an extended period, has encouraged investors to "reach for yield"--that is, to shift their portfolios toward riskier and longer-term securities, which generally have higher yields, to keep realized returns from falling. They also worry about the effects of a related behavior in which financial intermediaries borrow at low short-term rates to lend at higher long-term rates--the so-called "carry trade"--and about the effects of low interest rates on the prices of houses. To a considerable extent, these processes are part of the efficient functioning of markets: Investors should compare the return they would receive on holding short-term deposits or the cost of borrowing short-term to the potential returns on riskier assets and make investment decisions on the basis of the trade-off between return and risk. Indeed, behaviors of this sort transmit accommodative monetary policy through financial markets to accomplish its intended effect of stimulating demand. The issue is whether this process has gone too far--that is, whether investors are failing to take adequate account of the risks of those alternative investments. Forming such a judgment requires a view on the level of asset prices that would be "appropriate" given economic fundamentals. Unfortunately, economists are not very good at this, but neither is anyone else, including Wall Street analysts."

Remarks by Governor Donald L. Kohn At the Banking and Finance Lecture Series, Widener University, Chester, Pennsylvania April 1, 2004

I would suggest Governor Kohn has taken a creative approach to the application of Efficient Market theory. By one definition, efficient market theory holds that the "price" of a security reflects all of the available information about the economy, the market and the specific security, and that prices adjust immediately to new information.

Consequently, by implication, it is difficult to generate more than the "market" return by analyzing available information. An active market that includes many well-informed and intelligent investors, will be appropriately priced and will reflect all available information, thereby assuring resources are put to their most highly valued uses. Capital would be allocated to the most promising investment opportunities.

Confused? You are not alone as there are many adaptations. My apologies, let's simplify it into a broader, more palatable context. Market participants account for information and prices adjust rapidly towards "Investment Value", which represents the discounted value of the cash flow it is expected will be generated, with an appropriate discount rate given for risk, liquidity, etc.

I'm beginning to sound like an Economist, no wonder they cannot agree and when they do, it's probably time to re-consider. Let me attempt this again, one more time; The "Markets" are a discounting mechanism. How they go about discounting "information" is open to endless debate and I am not going to go there as the simple truths in life are usually the best.

Governor Kohn attempts to address "whether interest rates and asset prices have been pushed away from appropriate levels" by virtue of Federal Reserve monetary policy. I would suggest the very Financial and Economic "Value" propositions have been grossly distorted by Fed policy. In keeping short-term rates at very low levels for an extensive period, the Fed has encouraged investors to "chase yields" in order to maximize returns. A higher rate of return should always reflect the degree of risk. In contrast, on the short end the, Fed has managed to discourage "risk aversion" with low overnight rates.

Is this the Fed's idea of a "value proposition"? Are these the processes of an efficient, functioning of the market?

I would suggest the Fed is running interference and not allowing the market to discount the questionable quality of information provided, but instead is using its policy to intercept the very economic signals Governor Kohn suggests are at issue with respect to alternative investments.

What is "appropriate" is far less "intervention in the markets".

In no uncertain terms, intervention is sending all the wrong signals.

Which begs the question: Why ask a question, restate it and proceed to answer it with an "I don't know." The majority of investors were apparently led to believe the Fed's Board of Governors had the very answer you were seeking.

John Mackenzie

John Mackenzie manages private capital - Email: m2jrmfl@bellsouth.net

Copyright © 2004-2005 John Mackenzie

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