By Paritosh Bansal
(Reuters) – After navigating the 2008 financial crisis, Neel Kashkari worries about systemic risks. But now, as a US monetary policy maker, he is more worried about inflation.
“I think if I had to err, I’d err on the side of being a little bit aggressive about cutting inflation,” the Minneapolis Fed president told Reuters last week.
Surprised by persistent inflation in the face of the fastest rate hike cycle since the 1980s, Kashkari and some other federal officials have ramped up tensions again in recent days, with a hawkish view of interest rates.
In doing so, they may also be inadvertently setting the stage for the next market crisis and the Fed’s intervention, in turn, undermining the bank’s aggressive anti-inflationary policy.
So the Fed’s attempt to steer the economy into a so-called “soft landing” while maintaining financial stability instead increases the odds that it will be either a hard landing or a longer, more turbulent path on the ground.
“They are in a bit of a position where they are damned if they do, and damned if they don’t,” said Raghuram Rajan, former RBI governor and professor of finance at Chicago Booth. “If they raise short-term policy rates, obviously, at some point, something is going to break.”
Soft landing potential? “Very young,” said Rajan.
The Fed declined to comment.
Over the past year, the rapid rise in interest rates after more than a decade of very cheap money has exposed risky bets and bad business models.
Tensions have erupted in various parts of the global financial system, from the bursting of the crypto bubble a year ago to unrest in the regional banking sector in the United States in March.
While it is not clear where the next storm will hit the markets, potential sources of weakness abound, from commercial real estate to money market funds.
Needle thread
Markets have stabilized since the worst of the banking turmoil subsided. Signs that the economy is still resilient are making more investors bet that the Fed may cut inflation without causing too much economic pain or instability.
Earlier this month, Chairman Jay Powell said the Fed’s monetary policy and financial stabilization tools “work well together,” allowing it to support banks and their pursuit of price stability.
But many people in the market believe that not only is the regional banking sector still under pressure, but there are still many other risks to financial stability.
Tighter monetary policy could set it off or exacerbate the impact of other shocks, such as debt-ceiling negotiations. These bombings could lead to more interventions, which partially offset the tougher policy.
“The Fed doesn’t want to run monetary policy through financial crises,” said Wendy Edelberg, director of the Hamilton Project at the Brookings Institution. “And so they have to poke a needle if they see that their actions create crises. Then they need to mitigate that.”
Many risks
In the aftermath of the race for the Silicon Valley Bank (SVB) in March, the Federal Reserve was forced to step in with tens of billions of dollars in emergency support to the banking system. Some argue that he actually opposed her moves to tighten politics.
“The market is confused about whether the Fed is tightening or easing. We’re trying to follow what they’re going to do. And right now, the market doesn’t know which Fed to follow,” said James Tabachi, CEO of South Street Securities Brokerage.
Systemic trauma can come from both known and unexpected ways. In its latest Financial Stability Report earlier this month, the Fed listed several areas of concern, including life insurance and some types of bond funds and loans.
Kashkari of the Federal Reserve Bank of Minneapolis pointed to private markets, where although many experts expect risks to be limited, a lack of transparency means officials don’t fully understand the extent of the debt-fueled stakes. Nor is it always clear how financial institutions are interconnected.
“There’s a lot of complexity that we don’t have much insight into,” Kashkari said. “Unfortunately this may not be detected until there is a real problem.”
(Reporting by Paritosh Bansal; Editing by Anna Driver)
