Investment XYZ

Friday, June 30, 2006

The Myth of Dividend "Yields"

Stock dividends are periodic (regular or irregular) cash distributions to stock holders by the company. In some less common cases, the distribution can be in the form of stock (in shares) rather than cash. The amount distributed each time is typically small. For companies that distribute regular cash dividends (in the US, the frequency is typically quarterly), the annual dividends amount to about 2-4% of the stock value. But there are cases when the company is involved in a merger/acquisition/spin-off, such as the AT&T spin-off of the AT&T Wireless business; or a company distributes one time dividends to reduce its cash hoard (such as the one time $3.08 dividend by Microsoft in November 2004).

Extra Cash, No Extra Value

By the nature of dividends, it appears to stock investors that dividends are some "extra" cash they earn besides the holding of the stock asset. In fact, stock dividends are called "yields" in the similar parlance as bonds and cash, giving people an impression that dividends are similar to interest payments that "yield" from the bond or cash asset (so the stock can "yield" some cash in the form of dividends). That's quite an unfortunate and misleading name that gives investors a false sense of security. This article is to debunk this most common misunderstanding (and promoted myth) in stock investment. In fact, many analysts take dividend yield as one of the important criteria for picking stocks.

Dividend distribution has absolutely no impact (positive or negative) on investors' returns. On the date when the dividend distribution goes into effect (called the Ex-Dividend date, the date when the stock is traded without the dividends), the stock price should automatically drop by the exact amount of the dividend just distributed when the stock market opened. For investors, the equity value becomes the cash value (as distributed dividend) + equity with less value. The net value change before and after the distribution is zero. In other words, dividends distribution is exactly the same as if the investors had sold part of stocks.

But if you sell part of the stock, you have less shares, while with a dividend, there is no change in the number of shares you own. So isn't that a huge difference? That's a common illusion among investors -- it really doesn't matter how many shares one owns, what matter is the value of the equity, which is the shares times the equity price. In dividend distribution, there is no change in total value, even though there is no change in equity shares owned. Thus a 4% dividend yield stock does not mean you will have 4% returns. If there is no capital appreciation or depreciation, a 4% yield stock will give you 0% return.

Then how about comparing to bonds or cash? Don't they both distribute interests (as cash) in a similar way? How can a 8% yield bond or bank deposit give the investor 8% returns?

For cash deposits or private notes (bonds that can be purchased only at the time of issuance), there is no price drop at the time of distribution, thus it is easy to understand that bond and cash yields are real yields that are different from the stock "yields". For real yields, yield rate = return rate. But with public traded bonds that have regular distribution, there will be a price drop at distribution just like stock ExDiv so that no price arbitrage is possible, nevertheless this does not affect the yield. For the public traded bonds still the yield is a real yield (the underlying logic is the same as the case of private notes mentioned above).

What's the difference between bond/cash yield and stock "yield"? For the former, there is a guarantee for the asset price at the time of redemption, ie, the face value. For example, you buy $1000 6% yield 2-year maturity bond, that means you will have $120 of distributed cash, and at the time of maturity, you can redeem the bond for $1000. Obviously, for stocks there is no such guarantee for the stock prices at all. There is no such thing as "face value" for stocks.

Balance Sheet Differences

But for companies that distribute dividends, doesn't it work in the same way whether it is a bond distribution or a stock distribution, the cash comes out of the company's coffer? Yes, they are identical in the cash flow part. But on the balance sheet, cash coming out of the company does not mean it will increase the shareholder's net equity value. For stock dividend distributions in the company's balance sheet, the cash hoard ("asset") is reduced, thus there is a reduction in equity value (the book value) for the shareholders (there is no change in the liability part of the balance sheet). For bond distributions, the cash hoard is reduced, while the debt liability remains unchanged (the face value of the bond remain unchanged), resulting also in reduction in net value (while for bond holder, there is a net increase in value). In both cases, there is no separate entry on the balance sheet to indicate the amount of dividend or interest payments, and the reduction in equity is due to the reduction in the "retained earnings" entry for the shareholders -- since the company uses up some cash from income, the retained earnings are reduced.

For stock repurchase, there is a little difference in the number juggling, but the end result is the same (reduction in book value). The repurchased stocks are entered as "Treasury Stocks" in the "shareholder's equity" area on the balance sheet, as a negative number. Naturally the cash in the asset is also reduced correspondingly. Behind the balance sheet, the number of shares outstanding should be reduced since the company buys back its own stock (or the company can keep the shares outstanding unchanged with the intention to sell these repurchased shares -- or "treasury stocks" -- back on the market at a later time). In any cases, the end result is still a reduction in shareholder equity (book value).

To sum it up, if a company presents the balance sheet before and after the dividend distribution or bond interest payment, or stock repurchase, there should be a reduction in shareholders' equity (net equity value). The more the company pays dividends or buyback stock, the less the stock holders' equity on the balance sheet become. This is due to the convention that on the balance sheet, shareholder's equity value has nothing to do with the market price of the company equity (stock). In a sense, this is a reflection of the fact that the company has nothing to do with the market price of the stock, while the company has to back up the liability of its bonds.

Dividend Yield and Stock Volatility

Dividend distribution is offset by the stock price drop on Ex-Dividend date, resulting in no net returns, but for the long term, is it possible that stock will climb back to erase the drop caused by the distribution, thus making dividend distribution more like bond yield, at least statistically speaking?

The typical dividend yield is small when comparing with stock volatility. For the SP500 stocks that distribute dividends, the average annual yield rate is 2.1%, while the average volatility of the same group of stocks is an annualized 22%, or about 1.36% per day. In other words, the annual dividend yields on average are about the same amount as the stock daily fluctuations; or, for dividends distributed quarterly, the price drop at Ex-Dividend date is about 1/3 or 1/2 of typical stock daily fluctuations. Another way of saying it, is in considering the typical volatility of equity prices, the dividend yield is insignificant. For the wishful thinking that the ExDiv drops will be erased overall in the long term, note that with the annual stock fluctuation rate of 22%, trying to pick a trend off the 2.1% move is statistically meaningless.

Dividend Distribution is A Liquidity Event

You may still be unconvinced that dividends have no value for investors -- how can it not be good, if I get some extra cash, while in the mean time still owning the same number of shares? Besides, historically dividends are such an important part of returns for investors who invest in the private companies. Compare these two cases: you have the opportunity to invest in two private banks that run identical businesses, one distributes dividends regularly, the other never pays dividends. Obviously the first one is more attractive. You get a way of cashing out some of the returns, even though they both have the same intrinsic returns in equity value, and such returns may be higher than the dividend yield (of the first company).

What's liquidity? Liquidity is the ability of an asset to convert its value to cash. For example, a publicly traded stock can be sold and its value is converted into cash at any time as long as the stock is trading on the exchange. Thus publicly traded stocks have good liquidity. On the other hand, an art master piece may have high value but at the time when the owner want to realize such value, there may not be a market ready for him to sell the art piece to. Such asset obviously has poor liquidity. A liquidity event is a transaction that converts certain non-cash asset into cash. Thus liquidity event does not cause change in value (no profit/loss) except it may incur some transaction cost (such as commissions).

In the above example, pirvate businesses have poor liquidity in equity value since there is no easy market for the owner to convert the ownership into cash. Dividend distributions provide one small window for liquidity, thus it is valuable. However, for publicly traded companies, such liquidity from dividend distribution has no added value at all since the equity value itself is totally liquid in the marketplace, there is no difference between the extra liquidity from dividend distribution and the market liquidity of the equity itself. The cash from dividend distribution is exactly the same as the cash from selling shares in the market.

In fact, any investor can create quarterly dividends for any stocks of any public traded company that does not distribute dividends. All he needs to do is, at every quarter sells a certain fixed cash value (not fixed number of shares) of stock. The net result in returns for investors is exactly the same as if that company would distribute quarterly dividends.

Some people may still not buy such an argument: dividend distributions take cash away from the company's coffer, so it has economic impact for the company, thus there is be a net impact on the investors too, rather than a pointless liquidity event. First of all, when one uses cash to buy stock, the cash asset becomes equity, there is no net change in asset value. When a company distributes dividends, it converts portion of retained earnings into cash, while for stock repurchase, company converts part of retained earnings into treasury stocks. In both cases, there is a definite buyer opposite to investors that has committed cash to buy certain amount of equity. In comparison, if investors sell stocks, the opposite side is unknown but in a liquid market, the investor doesn't need to care who is on the other side of the trade. Coming back to the case of private companies or illiquid assets: since there is no ready buyers of the company equity at the time when the investors want to sell, thus the dividend events make the company itself as the only regular (partial) liquidity provider for the investors, which obviously is meaningful for investors. On the other hand, in a liquid public market, the company is one of the millions of buyers, and thus there is no particular significance for investors that their equities are being purchased by the company (through dividends or through share buyback), or by some other unknown parties.

While quarterly dividends distributions are usually well anticipated in the market and has no surprise to investors, the announcement from the companies of 1) dividend raise or 2) stock repurchase may typically be a positive surprise for the market and may see the equity price jump at the announcement due to the speculation; but such changes does not indicate any changes in returns, rather than it represents a liquidity event or a newsworth event that can move the market, just like the news of a big buyer in the market can push the stock higher momentarily.

In summary, 1) stock dividend distribution = company stock repurchase = investor partially selling shares to raise cash. 2) Dividend yield has nothing to do with equity investment returns. So what about the equity valuation theory that uses the dividend discount model (DDM) to estimate the current equity valuation? Isn't that using a liquidity event that has no relationship to equity value to construct an equity valuation model, in another word, totally voodoo science? Yes, I believe so. Though it is forgivable that it was a 1930s theory, unfortunately it has gained a new following in recent years, and as many analysts have been pulling investors' attention to dividend stocks all these years, the misconception of dividend as "yield" seems deep rooted. No matter how analysts promote it, dividends seem to be candies to help analysts or companies to sell shares, but there are no "fundamental" wealth benefits for investors. Dividends and stock buybacks represent big buyers of stocks in the market. Just like big buyers or sellers from big funds can bring significant liquidity and movements to the market, but it is just a liquidity event after all.

Postscript: Dividends and Options

Though I argue in this article that dividends have given investors no added value at all, dividends are a very important factor in option pricing. Why? By the contract term of equity options, the options give the holder the right to buy or sell stock at a set price ("strike") at or before a set date ("expiration date"). It says nothing of the dividend distribution during the life time of the option. The stock price drop at the ExDiv date becomes the preset event (rather than a stochastic event) that will impact the option pricing in a definite way. When dividends changes, the impact on the option prices are:

Dividend Change

Call Price

Put Price







Typically companies issues quarterly dividends that are predictable. The future dividend stream is projected into the option prices, so that at the option distribution dates (ExDiv date) there is no price jump or arbitrage opportunity for options, except in one case that requires judgment on "early exercise". Such a situation will be discussed in a separate article.

In general, dividend distribution will not cause any net value jump, either for stock holders or for option holders. Stock holders can totally ignore the dividend amount, because no matter what amount, there is no change in net value; while for options, the complications of dividends arise in two areas: 1) Future dividend stream needs to be projected correctly, otherwise, the option may be mispriced and become the target of arbitrage; 2) On the trading date before the ExDiv date, call option holders need to make a judgment for any in-the-money calls to decide whether to exercise early. Failure to do that, which can actually happen in the marketplace at substantial percentage, presents an arbitrage opportunity.

When stock holders notice the option traders paying so much attention to dividends, it doesn't mean dividends are of any importance to stock investments. In fact stock investors should just ignore dividends.

Some media articles/web sites promoting the dividend myth:

Pave the Road to Retirement With Dividends - Motley Fool.

Dividend Discount Model.

(The author can be contacted at

Friday, June 23, 2006

Trading Cash

Can you buy and sell cash? That sounds like a silly idea. Just like a cheesy mortgage agent trying to push a deal would say: "Cash is cash, you can't buy this $100 bill at any other price."

Really? You can't buy the $100 bill at a different price other than $100, but if you deposit the $100, one bank pays 5% interest, another pays 3.5%, that is certainly different prices in cash.

Interest rate obviously is the key factor in trading cash in ForEx market. In stock market, there is also opportunity for trading cash. Let's look at one example as it just happens today (6/23/06).

Pricing a Cash Takeout Stock

Anadarko Petroleum (APC), a natural gas, crude oil development and production company, announced this morning that it will acquire Kerr-McGee (KMG) and Western Gas Resources (WGR) in cash. We will look at the KMG part of the deal. APC will pay $70.5 per share in cash for all KMG shares. Furthermore, it is a friendly takeover and the KMG board already accepted the offer at the announcement. There is a very steep breakup fee if the deal doesn't go through. On Thursday KMG close at $50.3 so the offer price has a huge 40% in premium. The deal is expected to close at the end of third quarter.

So what do you expect KMG to trade today? $70.5?

Assuming there is no risk of the deal breakup (with the steep breakup fee), and no chance for any competing bids (with the steep premium), $70.5 seems to be right answer, but that's wrong. The correct answer is somewhere around $69.5. Here is how I come to this number:

Since the deal is to be close by the end of third quarter, there is about 110 calendar days from now. With bank interest rate around 5%, the interest incurred from now to deal close is about $1.0 per share. Thus the current fair price for the stock is $70.5 - $1 = $69.5. Otherwise if higher than that you might be better off just selling the cash to the bank. The fair price (or theoretical price) comes from the fact that you have to borrow $69.5 from the bank to buy 1 share of KMG, paying $1 interest until the deal close when you will sell the share for $70.5, resulting in no profit (thus no arbitrage).

Pseudo-Cash vs Cash

In reality, the trading of such "future pseudo-cash" like KMG stock is not so simple. The breakup risk is tiny, but not zero (that would reduce the price slight); the chance of competing bid is almost none, but not absolutely impossible (thus would increase the price slightly). But the biggest factor is supply/demand. Many of the KMG shareholders can take profits now even selling at the price below the "theoretical price" of $69.5. In the mean time there is less incentive to buy the shares because the speculative upside is limited. Such imbalance in buy/sell action (much more sells than buys) will cause the share price to go down, until the price is low enough to attract enough capital for the arbitrage traders: the trade of buying the underpriced "pseudo-cash" and sell the real cash to profit on the difference.

That looks like what happens on the first day after the deal is announced: At pre-market after the news breaks, a few trades happened around $69 -- close but below the theoretical price. Then after the market open, all the investors pour in to take profit. The sell orders push the price down to $68.4. That's more than $1 of cash arbitrage money. That leaves enough gap for the arbitrage trades to come in to pick up the $1 risk-free money.

It is an easy "prediction" for how this stock should move next: after the profit-taking volume dies down in the next few days, the stocks should be trading around $69 to $69.5, and as the time goes by, the interests component slowly goes down (thus the theoretical price goes up) and eventually the stock price should reach the cash offer price of $70.5. Anyone who want to arbitrage the cash should use their financing interest rate of their banks or brokers (currently 4% to 5%), and calculate the theoretical price (with the estimated calendar days remaining to the deal closing date) and trade the price difference between the cash and the pseudo-cash.

So cash can be traded even in stock market. The opportunity arises from 1) Interest rate differences; 2) the supply/demand imbalance, and 3) from the people who know how to calculate the interests and those who don't. You might think that only the arbitrage professionals can trade cash, but in fact the supply/demand imbalance is typically quite large that it leaves lot of riskfree cash for small investors to pick up.

Here are a few recent close cash deal examples: HD buying HUG (Hughes Supply); SuperValu and CVS buying Albertson's (ABS); Danaher Corp (DHR) buying Sybron Dental (SYD).

Option Pricing

How do you price the options in the cash takeout situation? You don't need Black-Scholes (which is wrong in these situations), just need some common sense and high school math. Rule#1: all out-of-money (relative to the cash offer price) options has 0 theoretical price. In the market place, this is typically represented by no-bid (0 bid price, but ask price can be any number). In the KMG cases, Aug 65 Put is price at 0 bid, 0.55 ask. July 65 Put actually has bid, priced at 0.15 bid, 0.2 ask (previous day prices: 14.6/14.7).

For in-the-money call option, you don't need to pay the full price for the stock until expiration (thus save you interests). So fair price should be: use the theoretical "present value" of cash offer price at the expiration as the stock price, then discount the interest it cost you for buying the options. Take the example of KMG July 55 Call. The cash offer price for stock is $70.5, the present value: $69.5, the present value at expiration is $69.2), the call option should be roughly 69.2 - 55 = 14.2. But paying $14.2 for the call would cost you 0.05 in interest payment, so the theoretical price of this call should be $14.2 - 0.05 = $14.15. In contrast, if you just take the cash offer price and put in the BS formula with 0 volatility, you get $15.73; If you use the present value of $69.5, you get $14.73. The market price of this call is 13.6/13.8. Thus if you have this call, you should continue holding it until expiration to realize $0.45 of riskfree value.

For in-the-money put option, it is always better to exercise it and earn interests, rather than sitting on the put. Thus the put price should be Strike - Cash Offer Price + Interest Earned on Strike from now to deal close. Note that the put price has nothing to do with expiration, namely all the puts of the same strike with different expirations should price the same. For example, for KMG July 75 Put, the theoretical price should be 75 - 70.5 + 1.0 = $5.5. In the market place, the bid/offer of the 75 put is all over the place: Jul: 4.3/9.0; Aug: 5.8/8.9; Oct: 6.1/6.7; Jan07: 5.8/6.9. It seems it is profitable to just sell these put (except Jul 75), but you might get immediately assignment and the profit of the price difference is about the same as the arbitrage cash/pseudo-cash difference already exists in the market (so would be easier just to buy the pseudo-cash -- i.e., the KMG stock -- on the market).

In summary, the theoretical option pricing for cash takeout stock (with absolute certainty of the deal) is:

1) OTM option (relative to cash offer price) = 0
2) ITM Call = (Present value of cash offer price at expiration) - Strike - (Interest Cost of Call from now to expiration)
3) ITM Put = Strike - (Cash Offer Price) + (Interest Earned on Strike from now to deal close)
(But should be exercised immediately if long).

Postscript: KMG ceased to exist

The above takeover deal was completed at the end August 2006. The last traded KMG stock price was 70.47, or almost exactly the takeout price of 70.50, as it should be.

(The author can be contacted at

Tuesday, June 06, 2006

Inflation: Phantom of the Fed?

Twice in a row, confusing "hawkish" words from the mouth of Fed Chairman Bernanke railed the market. First was in May 1 2006 when he spoke to CNBC anchor Maria Bartiromo that "investors had misinterpreted his recent congressional remarks as an indication the Fed was nearly done raising rates." The moment that his remarks hit the wire, the investors immediate got into action to misinterpret the misinterpretation and the market took a quick dive. Bernanke later regretted his "lapse of judgment". The second time was in June 5, speaking at a rare conference of the three central bankers of US, EU and Japanese. Together with the literally incomprehensible English language of Jean-Claude Trichet of ECB and Japanese Deputy Governor Toshiro Muto, the clearly spoken but murky in meaning language by Bernanke sent the stock market into another dive. Dow Jones Industrial Average was down nearly 200 points to the year's low.

Did the market "misinterpret" his words again? Or is the crash more of a judgment of investor confidence on Bernanke himself, rather than just the interest rate? After all, if it were just based on the interest rate, the bond market has already priced in more than a 50% chance of another 1/4 point rate hike in next Fed meeting since the last hike in May 10. Now such a chance would be close to 80% -- an increase, but hardly a surprise.

Let's step back and see how this chain of thought originates. The logic seems simple: what the Fed is concerned about is inflation. If the economy is too good, it causes inflation. To fight inflation, the Fed has to raise the interest rate; in general there is an inverse relationship between the interest rate and equity prices because investors are more likely to sell stocks and put the money in the bank, thus explaining the dive of the stock market. The chain of relations seems to very straightforward, so straightforward that the media picks it up, packages it as a sound bite and propagates it without any questions.

Inflation and Money Supply

First of all, what is inflation anyway? Inflation is defined as "the fall in the purchasing power of a money (i.e., a currency of a country)". Such a seemingly simple definition entails many extensions, particularly when it comes to how to measure inflation. In general there are two camps of thoughts: monetary supply vs price index:

1. Inflation is intrinsically related to money supply. However, that now is being called the "classical theory" of inflation measurement, implying there is a new theory -- which it seems Mr Bernanke happens to belong to (see next item). In this classical theory, if the government prints too much paper money, or there is too much liquidity (outstanding credits) in the banks, the purchasing power is decreased, thus causing inflation.

Money supply measured by the Fed is made up of 3 parts: 1) printed money in circulation, measured in M0; 2) Bank accounts (saving/checking/CD under $100K/money market), measured in M1 and M2; 3) All other CDs, Eurodollar deposits and repurchase agreements (repos, or just call it "glorified pawn shops" for easy understanding), recorded in M3. Two interesting observations: 1) credit issued by the banks are not included in any of the measurements. With the ever prevailing use of credit cards in place of cash, this missing piece in the money supply can be substantial; 2) The items included only in M3 are all biggies.

Interestingly, the US Fed stopped publishing M3 data, the broadest money supply data, on March 23, 2006. It seems with so much focus on inflation recently, that such event should deserve a huge spotlight and analysis. Nevertheless, there is little media coverage of this event, feeding some conspiracy theory that the Fed has something (bad) to hide. In any cases, if Bernanke is not an academian that is concerned with defending some theory (such as discrediting the "classic" money supply theory), shouldn't he, as the Fed chief hawkish on inflation, release or have some openness on the M3 data? After all, money supply is the source of inflation just by the definition of inflation.

Inflation and Prices

2. Inflation is related to prices, which leads to the so-called "Neo-Keynesians" theory. In this theory, inflation is measured by the price changes of a large number of selected goods and services in the economy. However, not all the relative price changes are the same, and their relationship with each other are far from uniformed or straightforward. In general, there are 4 kinds of goods and services that have quite different implications for inflation:

1) Goods for measurement of money, such as a gold and silver. Historically due to the physical characteristics and the limited accessibility of such heavy metals, they are natural carriers of values and were effective in preventing government from printing too much money -- until the end of Bretton Woods System in the 70s. Today, such goods are used as safe heaven against inflation, but hardly a true measure of purchasing power of money, especially gold which has little economic value than its safe heaven value.

2) Goods and services directly related to living. The prices of such a category are the "cost of living", which certainly impacts the consumers. The inflation in this price category would be most apparent for ordinary people.

3) Capital goods and services. The prices of this category impact directly on the business and economic cycles, the purchases of these goods and services are general recycled back into the economy as the increase in productivities and increase in values. If the economic activities are overheating, capital prices will have inflation. But for consumers, they may not directly feel such inflation on the capital cost. For example, if raw material prices increase, the increase in prices will be passed on to the consumers, thus there is inflation in the cost of living. On the other hand, if a company pays a premium to purchase a set of new machines to improve the productivity of manufacturing some consumer goods, the inflation impact on the consumers can be either way: if the company pass the capital cost into the prices of the produced goods, consumers will feels the inflation; however if the productivity and quality increase is so great due to the new machinery so that the prices of produced goods decrease, consumers will feel nothing or even see deflation.

The consistent increase in US productivity in recent decades, as well as the continuous supply of cheap manufactured products from China (which are purchased in the "capital goods" category and resold into the "consumer goods" category) indicate that there is an inverse relationship between the inflation in the cost of living vs the inflation in capital cost. With the factor in raw material costs, the total relationship is far from straightforward.

4) Labor. Labor cost straddles the cost of living and cost of capital categories. On one hand, increased labor costs put more money in consumers' hands, which may let consumers feel deflation rather than inflation. On the other hand, an increase in labor costs may make the cost of produced goods higher. However, just as with the case of capital costs, depending on the increase in productivity and quality accompanying the rise of labor costs, the impact on the consumers can be inflationary or deflationary, or nothing. One good example is China. In the past 30 years after the economic reform, the labor costs have increased by multiples of hundreds or thousands times (measured in terms of average salary), the inflation is relatively in check. The reasons are obvious: productivity jumps, quality of goods leaps, and the availability and choices of consumers goods increase tremendously. All these expand the horizon of consumer goods and services and keep the inflation at a modest pace, while at the same time creating more and more consumers.

Interest Rate

So how does the interest rate get into the picture? In all the above categories there is no mention of interest rates at all. Monetary supply includes the money printed by the Fed as well as credits issued by private banks. Thus in theory interest rate can be used as a lever to pull to control the money supply, and consequently the inflation.

Here is an heuristic way to explain how the interest rate would impact prices and ultimately inflation: 1) an increase in the interest rate makes the US dollar more attractive for cash investors, so that more dollars are purchased and decreases the printed money in circulation, thus reduce inflation. However, in this regard, one of the important measurements, the Eurodollar deposit (i.e., investors use of Eurodollar to purchase US dollars) as contained only in the M3 is no longer published by the Fed. 2) rate increase would reduce consumer credits, so that less consumer borrowing will cause price increases in consumer goods and services; 3) similarly, rate increases would increase the cost of business borrowing, so that slow down the business activities, thus reducing the upward price pressure for capital goods and services.

However, except for the first point, the relationship of a rate increase to the overall inflation is far from simple and linear. If the consumers mostly do not borrow to consume, the second point is less relevant to inflation; and increases in capital costs may not lead to increases in living costs, as we explained earlier that the relationship may work either way. Thus the net effect on the combination of second and third points indicates that it is not straightforward to assume that an increased rate will shoot down inflation. However, from the Fed's statements, they seems to link the faster pace of the economy with inflation (thus they want to choke off GDP growth if it is too high). Under the Fed's microscope, fast economic growth is a sin that needs to be stamped out.

Back to Normalcy, not Weaponry

In the economic world, too much of something is bad, so it is an accepted truth that too fast an economic development is not a good thing and need to be balanced. In a capitalist world, all these excesses have a way of balancing themselves out through the invisible hand. However, the Fed seems to be willingly playing a very visible hand to "adjust" the economy using a wrench of a single interest rate, based on a theory or a model. In a true capitalist world, the government should be the last one to play the role of the invisible hand. Actually the government is just one of the parties in this increasingly complex economic fabric. For the Fed to play a fair role, they should behave just like a good corporate citizen: control well the monetary supply (which is no one else's job except the Fed), and be open about it. The interest rate that the Fed can adjust, the Fed fund rate, which is no more than the rate that banks charge each other for overnight loans, is actually part of a much bigger financial world that should be self-adjusting just like other parts of the economic world. It is not a tool for the Fed to "fight" inflation, as the media sound bites indicate.

So why would Bernanke run around talking about inflation, overheating economy, and appearing hawkish while on the other hand ignoring or intentionally avoiding the Fed's duty of the money printing function and being open about it? There are many theories regarding the relationship of interest rates and inflations, but considering the complex world of interest rates (just look at how many theoretical interest rate yield curve models are out there) and price relationship among cost of living, cost of capital, cost of labor etc., wielding the interest rate stick as a willing weapon seems like a typical fight between scholars on the campus green, rather than a responsible government agency should do with the world's money. Is that possible Bernanke suffers from the typical academic disease that holding a theory as the truth and willing to fight tooth and nail to defend it?

Overnight interbank lending rate is one of the Fed's duties, just as is the duty of controlling the monetary supply. The current string of 16 rate hikes to 5% is the result of the artificially low rate (as low as 1%) to stimulate the economy at the time of the market crisis in 1998 to 2001. That is an example of using the Fed rate as a visible hand to move the economy by Bernanke's predecessor. There are good reasons (or excuses) for that when the market was in turmoil. Now the economy and the market are seems back on track. The Fed should slowly restore the rate to a normal level (as it has done so far since the Fed started increasing the rate in 2004). Bernanke and his Fed colleagues should tell the world that the string of rate hikes is to restore the rate to a normal level, rather than pretending that the Fed rate is an invisible hand they can move around to capture the ghost they release.

(The author can be contacted at

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