Amid calm, Fed brews up next storm and it’s not a part of the debt ceiling series

Amid calm, Fed brews up next storm and it’s not a part of the debt ceiling series

Neel Kashkari survived the 2008 financial crisis and is concerned about systemic risks. But now, as an American monetary policy maker, he is even more concerned about inflation.

“I think if I have to err, I would err on being too aggressive in reducing inflation,” said the president of the Federal Reserve Bank of Minneapolis to Reuters last week.

Surprised by the persistent inflation in the face of the fastest rate-hiking cycle since the 1980s, Kashkari and some other Fed officials have reignited the debate in recent days, adopting a hawkish view on interest rates. However, in doing so, they may inadvertently pave the way for the next market crisis and Fed intervention, which, in turn, undermine the central bank’s policy tightening efforts to combat inflation.

The Fed’s attempt to steer the economy toward a so-called “soft landing” while maintaining financial stability thus increases the likelihood of either a hard landing or a longer, turbulent glide to the ground.

“They’re a little bit damned if they do and damned if they don’t,” said Raghuram Rajan, former governor of the Reserve Bank of India and finance professor at Chicago Booth. “If they raise the policy rate in the short term, something breaks at some point.”

The chance of a soft landing? “Very small,” said Rajan.

The Fed declined to comment.

Over the past year, rapidly rising interest rates have exposed risky bets and flawed business models after more than a decade of ultra-cheap money.

Stress has flared up in various parts of the global financial system, from the bursting of the crypto bubble a year ago to the turmoil in the U.S. regional banking sector in March. While it is unclear where the next storm will hit the markets, potential sources of vulnerability are numerous, from commercial real estate to money market funds.

Markets have calmed down since the worst of the banking turmoil subsided. Signs of the economy’s resilience have given more investors confidence that the Fed can tame inflation without causing too much economic pain or instability. Earlier this month, Chairman Jay Powell said the Fed’s monetary policy and financial stability tools are “working well” to support banks and pursue price stability.

However, several market participants believe that not only is the regional banking sector still under pressure, but multiple other risks to financial stability persist.

A tighter monetary policy could reignite those risks or exacerbate the impact of other shocks, such as negotiations over the debt ceiling. These eruptions could force more interventions, partly offsetting the tightening policy.

“The Fed does not want to conduct monetary policy via financial crises,” said Wendy Edelberg, director of The Hamilton Project at the Brookings Institute. “So they have to pick up the thread again when they see their actions leading to crises. Then they have to soften it.”

In the aftermath of the run on Silicon Valley Bank (SVB) in March, the Fed had to intervene with tens of billions of dollars in emergency support to the banking system. According to some, this came at the expense of its pursuit of a tighter policy.

“The market is confused about whether the Fed is tightening or easing,” said James Tabacchi, director of broker-dealer South Street Securities. “We’re trying to follow what they’re going to do. And at this moment, the market doesn’t know which Fed to follow.”

Systemic shocks can come from both known and unexpected sources. In its most recent financial stability report earlier this month, the Fed identified several areas of concern, including life insurance, certain types of bond and credit funds.

Kashkari of the Minneapolis Fed pointed to private markets, where although many experts expect the risk to be limited, officials lack full visibility into the extent of debt-laden bets being made due to a lack of transparency. It is also not always clear how financial institutions are interconnected.

“There’s a lot of complexity that we don’t have much visibility into,” said Kashkari. “Unfortunately, that only becomes apparent when there’s a real problem.”

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