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Can the Fed fight inflation without triggering a meltdown?

After the recent turmoil in Britain, anxiety about the stability of the financial system is rising alongside interest rates

Jerome H. Powell, chair of the Federal Reserve, speaks during a news conference after a Federal Open Market Committee meeting in D.C. (Sarah Silbiger/Bloomberg News)

The warning signs of financial distress are flashing all over Wall Street. The Federal Reserve’s long-term shift to higher interest rates has triggered a volatile re-pricing of stocks, bonds and real estate while forcing firms and households and governments that loaded up on cheap credit to rethink their plans.

The dilemma now facing the Fed is whether it can raise interest rates high enough to break the back of inflation without triggering a meltdown on financial markets.

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Last month, we got a preview of what such a drama might look like. After Liz Truss, the hapless former prime minister of the United Kingdom, announced a tax cut that would have required significant new government borrowing, investors dumped government bonds, known as gilts. That had the effect of driving up interest rates and driving down the value of the British pound. Those higher rates, in turn, threatened the solvency of Britain’s private pension funds, which had all piled into a complicated derivatives trade that now required them to come up with trillions of pounds in additional collateral. Desperate for cash, the pension funds sold their gilts, turning what had been a bond market rout into a meltdown. To deal with the crisis, the Bank of England, which had been busy selling gilts to cool inflation, was forced to reverse course and announce it would buy as many gilts as necessary to stem the panic.

The turmoil in London sent stock and bond prices plummeting around the world, undermined the credibility of the Bank of England and forced Truss’s resignation. But on Wall Street and in Washington, where markets have been extraordinarily volatile and the appetite for buying bonds and other credit is waning, it was seen as a warning that something similar could happen here.

“What happened in the United Kingdom — some of that is a self-inflicted wound, but some of that is tremors of what’s happening in the global system,” former treasury secretary Larry Summers told global financiers and finance ministers in Washington last month at the annual meetings of the World Bank and International Monetary Fund. “When you have tremors, you don’t always have earthquakes. But you probably should be thinking about earthquake protection.”

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During a decade of artificially low interest rates, governments and businesses have taken on mountains of debt, there has been an orgy of overpriced and anti-competitive corporate mergers, and the financial system is rife with speculative excess.

Much of this speculation has taken place in what is broadly called the shadow banking system — opaque and unregulated markets that now provide the majority of credit to American businesses and households. The Trump administration was blithely dismissive about systemic risks piling up on its watch. The Biden crew has been noticeably more aggressive in demanding better and running “stress tests” to ensure that disruptions in the shadow system would not lead to a collapse of regulated banks.

But what regulators have not done is actually step in and force the financial wiseguys — the hedge funds, the high-frequency traders, the private credit funds, along with their pals on the prime brokerage desks of the major investment banks — to unwind their riskiest positions or shore them up with more of their own money.

In Britain, for example, as far back as 2018, regulators flagged the potential systemic risks posed by the interest-rate hedging strategies adopted by the pension funds. Yet lacking either backbone or imagination, they did nothing about it.

The reality is that the shadow banking system is now so big and so opaque, the trades and instruments so complex and intertwined, and the players so herd-like in their behavior that any dramatic move in the price of one security, one commodity, one currency — or the collapse of one player — can trigger a chain reaction that ultimately could crash the entire system.

That is what happened in 1997 during the Asian financial crisis. It happened a year later when the Fed was forced to rescue a highly leveraged hedge fund named Long Term Capital Management. It happened again in 2007 with the collapse of mortgage investment funds run by Bear Stearns. And after the recent turmoil in Britain, there is heightened concern it could happen again here.

Truss implosion shows big change in financial climate

As today, all those earlier crises occurred as the Fed and other central banks were moving to raise rates following an extended period of easy money and rampant speculation that inflated the value of financial assets.

When a credit bubble bursts, the ride down can be quick and bumpy.

We see that in the wild ride on the stock market over the past six months, the steep decline in bond prices, the wipeout in the cryptocurrency market and the cooling of home prices. Many, like Summers and J.P. Morgan’s Jamie Dimon, predict the bottom is not yet in sight.

We see it in the dramatic decline in investor demand for “leveraged loans” used to finance corporate takeovers and stock buybacks, forcing some of the biggest Wall Street banks to take hundreds of millions of dollars of losses on loans they made but could not resell.

In March 2021, Archegos Capital Management roiled stock markets and sent tremors through some of Wall Street’s biggest banks when it was unable to come up with the cash to cover losses on its highly speculative portfolio of derivative contracts known as “total return swaps.” In the end, officials at the hedge fund were charged with securities fraud, and Credit Suisse was forced to take a $5.5 billion loss, Nomura Holdings $2.8 billion, Morgan Stanley nearly $1 billion and UBS Group $774 million.

Of particular concern to both the Fed and the Treasury has been waning interest in the Treasury bond market. Foreign central banks and insurance companies whose returns are reduced by the rising value of the dollar have gone missing. Commercial banks seem to have decided they would rather continue to loan money to businesses and consumers than lend it to the Treasury. And as always happens when rates are rising, pension funds and money managers are reluctant to buy treasuries yielding 4 percent interest when they are fairly certain they soon will be able to buy bonds yielding 5 percent interest.

Tremors in Treasury bonds worry Wall Street and Washington

In response, the Fed has tried to increase the amount of readily available cash sloshing around the financial system by encouraging banks to borrow against the bonds they already own without having to sell them. There is also speculation that the Fed might ease up on regulations requiring banks to set aside some of their own capital to cover the risk that Treasury bonds might decline in value. At the Treasury, meanwhile, officials are considering the unusual move of borrowing new money to buy back old bonds for which demand is particularly low.

All of this concern about a financial crisis is putting pressure on the Fed to ease up on its plan to continue raising rates into the first half of next year and — perhaps even more important — cancel plans to sell off $1 trillion worth of Treasury and mortgage bonds that it accumulated staving off financial crises in 2008 and again in 2020. That strategy, known as “quantitative easing,” wound up flooding the financial system with $8 trillion created out of thin air.

So far, Fed officials have signaled their determination to continue selling off bonds and removing that cash from the economy, at least until there are clear signs that inflation is abating.

“They’re going to push until something breaks,” said Scott Minerd, global chief investment officer at Guggenheim Partners.

If and when that breaking point is reached, have no doubt that the Fed — like the Bank of England — will step in as the lender of last resort and promise to do “whatever it takes” to restore orderly trading in financial markets. And with that, the Fed will have been forced to call a cease-fire in its war against inflation and put a floor under the price of financial assets.

What Chair Jerome H. Powell and his colleagues are now discovering is that it is a lot easier to inject trillions of dollars into the economy to stave off calamity than to sop that money back up after the crisis has passed. Once banks, businesses and investors come to rely on that money and build their financial arrangements around it, any effort to withdraw it can cause a “dash for cash” as people rush to sell their holdings before prices fall even further.

And as with any old-fashioned bank, if everyone shows up at the shadow banking system demanding their money back, they will discover that the money is not there — not because it has been lost, but because it has been lent to someone else. The essence of every financial crisis is some form of a run on the bank.

The challenge the Fed now faces is figuring out how to remove its cash from the financial system without spooking everyone else into removing theirs.

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