In the Market: Amid the calm, the Fed brews the next storm
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[May 30, 2023] By
Paritosh Bansal
(Reuters) -Having navigated the financial crisis of 2008, Neel Kashkari
worries about systemic risks. But now, as a U.S. monetary policymaker,
he worries even more about inflation.
"I think if I had to err, I would err on being a little bit too
aggressive in terms of bringing inflation down,” the president of the
Federal Reserve Bank of Minneapolis told Reuters last week.
Surprised by the persistence of inflation in the face of the fastest
rate hike cycle since the 1980s, Kashkari and some other Fed officials
have turned up the heat again in recent days, with a hawkish outlook on
interest rates.
In doing so, they may also be inadvertently setting the stage for the
next market crisis and Fed intervention, in turn, undercutting the
bank's policy tightening to fight inflation.
So the Fed's attempt to guide the economy to a so-called "soft landing"
while preserving financial stability is instead increasing the odds that
it will either be a crash landing or a longer, more turbulent glide path
to the ground.
"They're a little bit in a situation where they're damned if they do,
and damned if they don't," said Raghuram Rajan, the former Indian
central bank governor and finance professor at Chicago Booth. "If they
do raise short-term policy rates, clearly, at some point, something more
breaks.”
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The probability of a soft landing? "Very small," Rajan said.
The Fed declined to comment.
Over the past year rapidly rising interest rates after more than decade
of ultra-cheap money have exposed risky bets and bad business models.
Stress has flared up in different parts of the global financial system,
from the bursting of the crypto bubble a year ago to turbulence in the
U.S. regional banking sector in March.
While it is not clear where the next storm would hit markets, the
potential sources of vulnerability are many, from commercial real estate
to money market funds.
THREADING A NEEDLE
Markets have settled down since the worst of the banking upheaval
receded. Signs that the economy remains resilient also have more
investors betting the Fed could bring inflation down without causing too
much economic pain or instability.
Earlier this month, Chairman Jay Powell said the Fed's monetary policy
and financial stability tools were "working well together," allowing it
to support banks and pursue price stability.
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The U.S. Federal Reserve building is
pictured in Washington, March 18, 2008. REUTERS/Jason Reed/File
Photo/File Photo
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But several people in the market believe not only is the regional
banking sector still under stress, multiple other risks to financial
stability also remain.
Tighter monetary policy could well cause them to blow up or worsen
the impact of other shocks, such as debt ceiling negotiations. Those
flare ups could force more interventions, partially offsetting
tighter policy.
"The Fed has no desire to conduct monetary policy through financial
crises," said Wendy Edelberg, director of The Hamilton Project at
the Brookings Institution. "And so they have to thread a needle if
they see their actions creating crises. Then they need to mitigate
that."
MANY RISKS
In the aftermath of the run on Silicon Valley Bank (SVB) in March,
the Fed had to step in with tens of billions of dollars of emergency
support to the banking system. Some argue that in effect countered
its moves to tighten policy.
"The market is confused as to whether the Fed is tightening or
easing,” said James Tabacchi, chief executive of broker-dealer South
Street Securities. "We try to follow what they're going to do. And
right now, the market doesn't know which Fed to follow."
Systemic shocks could come from both known and unexpected avenues.
In its most recent financial stability report earlier this month,
the Fed listed several areas of concern, including life insurance
and some types of bond and loan funds.
The Minneapolis Fed's Kashkari pointed to private markets, where
although many experts expect risk to be limited, lack of
transparency means that officials do not fully understand the extent
of debt-fueled bets that have been taken. It is also not always
clear how financial institutions are interconnected.
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"There's a lot of complexity out there that we don't have great
visibility into," Kashkari said. "That unfortunately may not get
revealed until there is a real problem."
(Reporting by Paritosh Bansal; Editing by Anna Driver)
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