Amid the calm, the Fed prepares for the next storm

By Paritosh Bansal

(Reuters) – After weathering the 2008 financial crisis, Neel Kashkari worries about systemic risks. But now, as a US monetary policymaker, he worries even more about inflation.

“I think if I were to be wrong, I would be wrong by being a little too aggressive in terms of reducing inflation,” 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 a few other Fed officials have turned up the heat again in recent days, with a hawkish outlook on interest rates. ‘interest.

By doing so, they may also inadvertently set the stage for the next market meltdown and Fed intervention, in turn undermining the bank’s policy tightening to fight inflation.

So the Fed’s attempt to steer the economy into a so-called “soft landing” while preserving financial stability instead increases the odds of it being a hard landing or a longer slide. and more turbulent towards the ground.

“They’re in a bit of a situation where they’re damned if they do, and damned if they don’t,” said Raghuram Rajan, India’s former central bank governor and Chicago Booth finance professor. . “If they raise key rates in the short term, it is clear that at some point something more breaks.”

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

The Fed declined to comment.

Over the past year, the rapid rise in interest rates after more than a decade of ultra-cheap money has exposed risky bets and bad business models.

Stress has erupted in different parts of the global financial system, from the bursting of the crypto bubble a year ago to the turmoil in the US regional banking sector in March.

While it’s unclear where the next storm would hit markets, there are many potential sources of vulnerability, from commercial real estate to money market funds.

THREADING A NEEDLE

Markets have calmed down since the worst of the banking turmoil subsided. Signs that the economy remains resilient are also prompting more investors to bet that the Fed could bring inflation down without causing too much pain or economic instability.

Earlier this month, Chairman Jay Powell said the Fed’s monetary policy and financial stability tools “work well together,” allowing it to support banks and seek price stability.

But several people in the market believe that not only is the regional banking sector still under stress, but many other risks to financial stability also remain.

A tightening of monetary policy could well cause them to explode or aggravate the impact of other shocks, such as the debt ceiling negotiations. These surges could force more interventions, partly offsetting a stricter policy.

“The Fed has no desire to carry 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 have to mitigate that.”

MANY RISKS

In the aftermath of the Silicon Valley Bank (SVB) run in March, the Fed had to step in with tens of billions of dollars in emergency support for the banking system. Some argue that indeed countered his policy tightening moves.

“The market is confused about whether the Fed is tightening or easing,” said James Tabacchi, managing director at broker-dealer South Street Securities. “We’re trying 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 known and unexpected pathways. In its latest financial stability report earlier this month, the Fed listed several areas of concern, including life insurance and certain types of bond funds and loans.

Minneapolis Fed’s Kashkari pointed to private markets, where while many experts expect risk to be limited, lack of transparency means officials don’t fully understand the scale of debt-fueled betting. who were taken. Similarly, how financial institutions are interconnected is not always clear.

“There’s a lot of complexity that we don’t have great visibility on,” Kashkari said. “It will unfortunately not be revealed until there is a real problem.”

(Reporting by Paritosh Bansal; Editing by Anna Driver)

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