Federal Reserve policies and systemic instability: decoupling asset pricing from underlying risks

Dennis Keller, Co-founder, President and CEO; Philip Basil, Director of Banking Policy

While the Federal Reserve (“Fed”) is currently primarily focused on inflation and the Fed’s fight against it, the big missing story is how the Fed’s actions over the past 14 years have created many of the most significant risks and problems the we have face today. The Fed’s actions since the 2008 global financial crisis — including zero/near-zero interest rates and massive asset purchases — decoupled asset pricing from risk and sparked an historic credit and debt frenzy. The result is a series of risks that threaten to unravel dramatically and have devastating consequences.

Our report examines how we got here, the risk implications of the Fed’s past actions, and what the Fed needs to do to avoid making similar mistakes in the future.

Fed actions caused risk mispricing and debt accumulation by making credit abnormally cheap and encouraging indiscriminate risk-taking

The federal funds rate has been near zero for nine of the past 14 years and otherwise at historic lows until around mid-2022. Asset purchases intended to depress longer-term interest rates (so-called “quantitative easing”) increased the Fed’s balance sheet almost fivefold to $4.4 trillion before the 2020 pandemic, after which it added a staggering $4.5 trillion and nearly doubled its balance sheet again to a shocking $8.9 trillion.

As a result, between the 2008 crash and the 2020 pandemic, growth in non-financial corporate credit and non-mortgage consumer credit was 90% and 30% greater, respectively, than their growth before the 2008 crash. In the last two and a half years alone, they’ve been shocking 10% grown. Additionally, with massive outpourings of liquidity, the “risk per dollar” reflected in credit spreads fell significantly regardless of the actual underlying risks, with spreads for the riskiest companies hitting lows in 2021 not seen since 2007 , and debt issuance for them has been doing well beyond historical highs.

The Fed ignored the ill effects and warning signs of its policies

The Fed has been so focused on keeping its monetary policy actions “accommodative” and on short-term financial market conditions that it has ignored the medium- and longer-term negative effects of its monetary policy actions, as well as several red flags when analyzing the duration and to what level of its actions should progress. For example, the Fed continued its massive asset purchases through March 2022 — two full years after the 2020 pandemic — even as inflation rose to over 8% year-on-year. Simply put, there was no margin for error.

The risks from the Fed’s inflation-related turnaround are increasing

Now that the Fed is moving swiftly and forcefully in the opposite direction, raising rates and reducing its balance sheet, risk is being reassessed and asset prices have collapsed. Credit spreads on the riskiest bonds, as well as many creditworthy bonds, have widened by around 50% in the past year alone, resulting in significant falls in market values ​​and making it much more difficult for companies to borrow. If this continues and years of mispriced risk and uncontrolled leverage unravel, defaults are likely to increase, potentially sparking contagion and undermining financial stability.

Looking ahead, the Fed needs to avoid past mistakes

Over the past 14 years, the Fed has ignored some of its own core risk management principles and allowed significant risks to build up. It paid far too little attention to the entrenched expectations surrounding its highly accommodative policies among financial markets, companies and consumers, and it simply didn’t see itself as a potential source of risk – or didn’t see or consider itself. Without a thorough assessment of Fed actions, we risk repeating the same mistakes and throwing the US into a series of highly abnormal boom-and-bust cycles driven almost entirely by monetary policy. Such a cycle must be avoided for the benefit of our economy and the livelihoods of all Americans.

Find out more in our full report here.