[W]e tend to view financial risk taking as a purely intellectual activity. But this view is incomplete. Risk is more than an intellectual puzzle — it is a profoundly physical experience, and it involves your body. Risk by its very nature threatens to hurt you, so when confronted by it your body and brain, under the influence of the stress response, unite as a single functioning unit. This occurs in athletes and soldiers, and it occurs as well in traders and people investing from home. The state of your body predicts your appetite for financial risk just as it predicts an athlete’s performance. …
Our challenge response, and especially its main hormone cortisol (produced by the adrenal glands) is particularly active when we are exposed to novelty and uncertainty. If a person is subjected to something mildly unpleasant, like bursts of white noise, but these are delivered at regular intervals, they may leave cortisol levels unaffected. But if the timing of the noise changes and it is delivered randomly, meaning it cannot be predicted, then cortisol levels rise significantly.
So what does this mean for financial markets?
When opportunities abound, a potent cocktail of dopamine — a neurotransmitter operating along the pleasure pathways of the brain — and testosterone encourages us to expand our risk taking, a physical transformation I refer to as “the hour between dog and wolf.” One such opportunity is a brief spike in market volatility, for this presents a chance to make money. But if volatility rises for a long period, the prolonged uncertainty leads us to subconsciously conclude that we no longer understand what is happening and then cortisol scales back our risk taking. In this way our risk taking calibrates to the amount of uncertainty and threat in the environment.
In this light, the Federal Reserve has another parameter to consider.
THE Fed, however, through its control of policy uncertainty, has in its hands a powerful tool for influencing risk takers. But by trying to be more transparent, it has relinquished this control. …
As uncertainty in fed funds declined, one of the most powerful brakes on excessive risk taking in stocks was released.
During their tenures, in response to surging stock and housing markets, both Mr. Greenspan and Mr. Bernanke embarked on campaigns of tightening, but the metronome-like ticking of their rate increases was so soothing it failed to dampen exuberance.
There are times when the Fed does need to calm the markets. After the credit crisis, it did just that. But when the economy and market are strong, as they were during the dot-com and housing bubbles, what, pray tell, is the point of calming the markets? Of raising rates in a predictable fashion? If you think the markets are complacent, then unnerve them. Over the past 20 years the Fed may have perfected the art of reassuring the markets, but it has lost the power to scare. And that means stock markets more easily overshoot, and then collapse.
The Fed could dampen this cycle. It has, in interest rate policy, not one tool but two: the level of rates and the uncertainty of rates.
I like this analysis, but I’m not sure about the conclusion. Reserve banks operate under an illusion of control, acting as though they are behind the wheel of a finely tuned sports car. The reality is closer to 19th century medicine. Even if Coates’s analysis is right, I’m wary of the Fed or other reserve banks trying to generate the “right level” of uncertainty.