The Federal Reserve is raising interest rates at its fastest pace in decades to stem inflation, but Chairman Jerome Powell says the banking and financial sectors well equipped to handle the blow.
After the Federal Open Market Committee raised the benchmark interest rate by three-quarters of a percentage point on Wednesday, Powell said well-capitalized banks, responsive markets and strong household balance sheets painted a “pretty decent picture” of financial stability.
Others are less confident.
“The risk of economic stagflation is much greater for the market than for the Fed [Treasury Secretary] Janet Yellen I want to admit; the risk of institutional failure is greater than what the chairman acknowledged at a press conference this week,” said Kamal Sri-Kumar, a senior fellow at the Milken Institute and an independent macroeconomics consultant. “The Fed and Treasury are trying to be optimistic in public, but I hope that doesn’t reflect what they’re doing internally to prepare for these events. »
Sri-Kumar is one of several economists and policy experts who believe that a sharp rate hike by the Fed could be a greater threat than Powell acknowledged.
The FOMC raised its target range for the federal funds rate by 0.75 percentage points at two consecutive meetings and by 2.25 percentage points overall over the four months. The pace of tightening is ahead of anything the Fed has seen in 40 years.
Financial institutions have had little time to adjust to the accelerated tightening cycle. When the Fed began raising interest rates in March, most FOMC members expected to reach the current rate sometime next year, according to the committee’s Economic Project Summary. Since then, the Fed has taken a more aggressive stance, pledging to act “promptly” to make its monetary policy less accommodative – and, if necessary, tighter – to curb soaring inflation.
Interest rates change faster than capital markets can adjust increases the risk of default on loans and other financial instruments.
When such exposure is concentrated in large institutions, the ripple effects can have systemic effects. This was the case with hedge fund Long-Term Capital Management in 1998, which required a $3.6 billion Fed-brokered recapitalization.
Powell brushed off those concerns during a press conference after Wednesday’s FOMC meeting. He said asset prices had already fallen in anticipation of higher interest rates, reducing the risk of a quick sell-off. He also noted that public debt is close to a historic low. There are risks, he said, but not at a system-wide level.
“There are a lot of macroeconomic issues that don’t rise to the level of financial stability issues,” Powell said. “Financial stability, you know, we see those as things that can undermine the financial system. Such big, serious things.”
Still, Powell’s reasoning left some unsatisfied. Jeremy Kress, a professor of commercial law at the University of Michigan and a former Federal Reserve attorney, answered the question of how a rapid increase in interest rates will be absorbed by financial institutions of all stripes, it is too complex to simply consider debt levels and asset prices.
“This is an answer to the question of financial stability through the lens of monetary policy,” Kress said. “The real answer would be something more modest in terms of acknowledging that this is something the Fed should be looking at because it hasn’t looked at it formally.”
Derek Tang, co-founder and managing partner of Monetary Policy Analytics, also felt that Powell’s position on systemic risks lacked nuance.
“[Powell] did not pay enough attention to the potential amplifying effects of rapid rate hikes and how volatility can only emerge with a lag,” Tan said. “His argument that strong balance sheets are a strong buffer may actually mean that some problems are hidden until things get worse.”
Powell highlighted the banks’ ability to reduce volatility with their strong capital, as evidenced by the results of this year’s stress test, in which all 33 banks tested passed relatively easily. But both Tan and Kress questioned whether this year’s stress test scenario was comparable enough to draw meaningful conclusions.
“These stress tests developed in February had much lower interest rates,” Tan said. “Therefore, this stress test does not reflect large fluctuations in yields since then.”
The Fed’s stress tests, which regularly examine how a change in interest rates would affect banks, are not designed to simulate actual or projected market conditions, but rather to assess how banks would perform when faced with difficult, imaginary scenarios.
In addition to the stress tests, Fed staff focused on the impact of high inflation and rising interest rates. It is noticeable in them more the latest Financial Stability Report in May and was listed as the No. 2 concern for market participants only behind the Russian invasion of Ukraine.
The topic of financial stability is a difficult one for the Fed chairman to be honest, Sri-Kumar said. According to him, a claim that there is no possibility of a systemic failure can push the market to take unnecessary risks, while a claim that a failure is inevitable can have a dire effect.
“Internally, they’re aware of that and they’re looking at that risk,” Sri-Kumar said. “Regulators should be concerned about financial stability right now, but they’re not going to admit it publicly.”