The US Fed’s pace of rate hikes will determine accident risks

Consider the US Federal Reserve. Having badly misdiagnosed inflation last year and fallen behind its price-stability mandate, it has intensified its policy response over the last few months. The June rate increase of 75 basis points was the first of that size in 28 years, and it was followed by two likewise increases, a record, with a third one expected at its next meeting. This Fed rate-increase cycle, which has already delivered a total of 3 percentage points in just over six months, is the most front-loaded one in a long time. A cooling US housing market, sharp appreciation of the US dollar and the headaches given to other countries worldwide are examples of its effects.

Yet, reflecting how tardy the US Fed’s response has been, financial markets are pricing in an additional 1.75 to 2 percentage points of rate hikes in this cycle. Drawing on Chair Jerome Powell’s repeated references to Paul Volcker, the 1980s central banker famous for crushing inflation, quite a few expect high rates to persist for a while.

No wonder the laments that, having to play catch-up, the world’s most powerful central bank risks pushing the US economy into recession, throwing millions of people out of work, worsening income inequality, undermining its independence and lighting economic fires around the globe. It is a concern amplified by an operational approach that relies heavily on lagging data and still seems governed by an outdated monetary policy framework. Yet, also as worrisome, is the possibility that an early ‘pivot’ in Fed policy would risk leaving America’s economy in a stagflationary swamp.

This delicate balance between reducing inflation and limiting the hit to economic well-being is all the more complex because of financial stability worries, including the pronounced threats of malfunction in G7 government bond markets at the core of financial intermediation. The weakest links are in leverage. Derivative-heavy chains have migrated out of banks to non-banks that are both less well supervised and regulated. This was vividly illustrated a few weeks ago by the near-collapse of firms serving the UK pension system.

The faster the rate-hike cycle, the greater the risk of financial accidents with nasty spillovers. After all, the financial system did what it was incentivized to do during more than a decade in which markets were conditioned to believe in the longevity of a policy regime that floored rates at zero or negative rates, injected trillions of dollars of liquidity and reinforced the belief in a ‘central bank put’ that shielded markets not only from large asset price declines, but also what was once deemed normal volatility.

The system’s optimization of that regime involved large debt and leverage; over-adherence to unrealistic return objectives; and, for many, venturing well beyond their natural investment habitat and expertise. Even though the skew of each factor was distorted and artificial, it seemed tilted in a highly favourable way by central banks’ delivery of the three things that matter most to investors: high returns, low volatility and favourable correlations.

Inflation and monetary policy changes that it entails require an orderly reversal of that, which is easier said than done. That has spurred concerns about the pace of the Fed’s rate hikes increases. If the Fed is not careful, well-intended policy actions could cause not just a recession, but also an accident of disorderly deleveraging and disruptive contagion all across.

In theory, the Fed’s growth and financial stability challenges could be resolved without harming the battle against inflation by convincing markets that its rate destination remains the same but the journey will be prudently slower. In practice, this is hard for a central bank that, to cite the president of the Philadelphia Fed, is associated with a “frankly disappointing lack of progress on curtailing inflation.” The Fed is stuck in a 3-D rock-versus-hard-place situation.

The speed with which interest rates are going higher for longer, while needed to curb inflation, increases the risk to financial stability. If only all the earlier talk of transitory inflation, soft landings and immaculate disinflation had not delayed policymakers’ reactions and market adjustments. Now that time is against it, the Fed will need even greater skill, and a lot more luck, to navigate such a complex inflation-growth-stability configuration.

Mohamed A. El-Erian is president of Queens’ College, Cambridge, and a former chief executive officer of Pimco.