Analysis: As Markets Worry, Fed Officials Dismiss Rising Financial Stability Risks

NEW YORK, Oct 13 (Reuters) – Federal Reserve officials are pushing back on growing investor concerns that the U.S. central bank’s aggressive campaign to counter high inflation is setting the stage for a market crunch.

Central bankers’ confidence is being thwarted by widespread fears among market participants who see strains on bond market liquidity, damaging declines in asset prices as well as a range of problems in overseas markets. Some view this landscape as dire enough to call on the Fed to slow down or even consider halting its interest rate hikes, something officials have so far shown no appetite for as they do faced with the worst surge in inflation in 40 years.

“We have to watch things in the financial markets, and we have to look for vulnerabilities as you raise rates,” Cleveland Fed President Loretta Mester told reporters on Tuesday, especially in an environment where all major The world’s central bankers are moving in the same direction toward tighter monetary policy.

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“That’s when these vulnerabilities that you don’t necessarily normally see and change rates can show up,” Mester said. But as things stand, “I don’t see any big hidden risks hanging over” and “there is no evidence that a disorderly functioning of the market is currently playing out.”

So far, the Fed’s liquidity tools have shown no signs of market distress. Foreign central banks have not operated a tool that lends dollars of any notable size, and other lending facilities have yet to see unusual activity. A measure of market stress produced by the St. Louis Fed suggests financial stress is below average.

The view outside the Fed, however, is quite different.

“Global markets are increasingly showing signs of instability,” said Roberto Perli, head of global policy research at Piper Sandler. “The starkest example is the UK, where the Bank of England has already been forced to step in to shore up pension funds, but there are cracks in Europe (emerging markets) and the US also.”

Tobias Adrian, director of money and capital markets at the International Monetary Fund, wrote on Tuesday that risks to financial stability have increased “substantially”. Adrian, who worked at the New York Fed, pointed to growing signs of trouble for global government debt markets at a time when borrowing levels are high. Risk-taking is also down, and tight markets risk spreading any shocks that may arise, Adrian said.

Moreover, the pressure on the markets could become even more pronounced as major central banks continue to raise the cost of credit.

ROOM TO TIGHTEN UP

Financial conditions have tightened rapidly this year and have plenty of room to get even tighter, according to new data from Bank of America. He said his recently launched U.S. Financial Conditions Indicator shows the speed of the tightening could be more noticeable than the actual level of tightening, which so far remains below other bouts of turbulence.

The index went from neutral to its current level in 10 months. It took five years during the last Fed rate hike cycle.

“If past cycles are any guide, financial conditions may tighten – and may need to – to generate the easing in labor market conditions the Fed desires, especially in an environment where reopening forces are generating a exceptionally strong labor demand,” the bank said. American economists have written.

The Fed has raised its target range for the overnight rate at a pace that breaks with the gradual approach used over the past few decades. Fed officials raised the federal funds rate from levels near zero in March to the current range of between 3.00% and 3.25%.

Financial markets expect the Fed to hike the rate another three-quarters of a percentage point at its next policy meeting in November. Further rate hikes are very likely after that, with central bankers forecasting a federal funds rate of 4.6% by some point in 2023.

Making financial conditions more restrictive is essential to the functioning of monetary policy. By raising the cost of credit and making it more expensive to take risk and invest, the Fed is dampening overall economic momentum and reducing inflationary pressures.

On Friday, a senior Fed official said monetary policy could play a bigger role in economic momentum than many realize. New York Fed President John Williams said so-called neutral interest rates are “just a lot lower now” than in the recent past. This means that in real terms, the current fed funds rate is “actually tighter monetary policy than it would be in, say, the early 90s or something.”

It remains unclear how the Fed might respond to market difficulties. Financial stability is central to its mission, so a big meltdown would likely elicit some sort of reaction. San Francisco Fed President Mary Daly said last week “we definitely won’t raise rates until something breaks.”

But Fed Governor Christopher Waller, speaking last week, said he was “a bit confused” by concerns about risks to financial stability. “While there has been increased volatility and liquidity stress in financial markets recently, overall I think the markets are working efficiently,” he said, adding that he doubted that a market problem is affecting the outlook for rate hikes.

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Reporting by Michael S. Derby; Editing by Dan Burns and Paul Simao

Our standards: The Thomson Reuters Trust Principles.

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