Analysis – As markets fret, Fed officials dismiss the idea of ​​rising risks to financial stability

By Michael S Derby

NEW YORK (Reuters) – Federal Reserve officials are pushing back on mounting investor concerns that the Federal Reserve’s aggressive campaign to combat high inflation is setting the stage for a markets collapse.

Confidence among central bankers is offset by broader concerns among market participants, who see liquidity squeezes in bond markets, damaging asset price declines and a range of problems in overseas markets. Some see this landscape as bleak enough to urge the Fed to slow or even consider slowing its rate hikes, something officials have so far shown no appetite for as they grapple with the worst inflationary spurt in 40 years.

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

“Then these vulnerabilities can appear that you don’t necessarily see in normal times and the tariffs don’t change,” said Mester. But as of today, “I don’t see any hidden major pending risks out there” and “there is currently no evidence that the market is functioning disorderly.”

So far, the Fed’s liquidity tools have shown no sign of market trouble. Foreign central banks have not tapped into any instrument lending significant amounts of dollars, and other lenders have not yet seen any unusual activity. A measure of market stress produced by the St. Louis Fed suggests that financial stress is below average.

However, the view outside of the Fed is very different.

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

The story goes on

Tobias Adrian, director of money and capital markets at the International Monetary Fund, wrote on Tuesday that risks to financial stability had increased “significantly”. Adrian, formerly at the New York Fed, pointed to increasing signs of trouble for global government bond markets at a time of high borrowing. Risk appetite is also declining, and thin markets carry the risk of any shocks spreading, Adrian said.

In addition, pressure on markets could intensify as major central banks continue to raise borrowing costs.

ROOM TO GET TIGHTER

Financial conditions have tightened rapidly this year, leaving plenty of room for even tighter measures, according to new Bank of America data. The newly launched indicator of US financial conditions shows that the pace of the tightening may be more remarkable than the actual rate of tightening, which has so far been below other episodes of turbulence.

The index has climbed from neutral to current levels in 10 months. That lasted five years in the Fed’s last rate hike cycle.

“If previous cycles are any guide, financial conditions can – and may have to – tighten to produce the softening in labor market conditions the Fed wants, especially in an environment where reopening forces are creating exceptionally strong demand for labour ‘ Bank of America economists wrote.

The Fed has pushed up its daily target range at a pace that breaks with the gradual approach of the last few decades. Fed officials raised the federal funds rate from near zero to the current range of 3.00% to 3.25% in March.

The financial markets are expecting the Fed to raise interest rates again by three-quarters of a percentage point at its next monetary policy meeting in November. After that, further rate hikes are very likely as central bankers are set to implement a 4.6% policy rate through 2023.

Tighter financing conditions are key to how monetary policy works. By raising the cost of borrowing and making risk-taking and investment more expensive, the Fed is cooling overall economic momentum and lowering inflationary pressures.

On Friday, a senior Fed official said monetary policy could take a bigger bite out of economic momentum than many realize. New York Fed President John Williams said so-called neutral interest rates are “just a lot lower now” than they have been in the recent past. In real terms, that means the current federal funds rate “is actually tighter monetary policy than it would have been, say, in the early 1990s or so.”

It remains unclear how the Fed might respond to market problems. Financial stability is at the core of its mission, so a major meltdown would likely provoke some kind of reaction. San Francisco Fed Chair Mary Daly said last week, “We’re definitely not raising rates until something breaks.”

But Fed Governor Christopher Waller said last week he was “a little confused” by concerns about risks to financial stability. “Although there has been increased volatility and liquidity stress in financial markets of late, I believe overall markets are functioning effectively,” he said, adding that he doubted a market problem would affect prospects for a rate hike.

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