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Fed flags financial stability risks

May 11, 2021

Changes in the Federal Funds Target during S&P 500 Corrections and Bear Markets chart

Source: Federal Reserve Board of Governors and Standard and Poor’s

The Federal Reserve’s latest Financial Stability Report warned of the risks associated with elevated asset values, noting that a decline in risk appetite could lead to broader stress in the financial system. This is an obvious tautology, but it highlights that, for all the recent focus on transitory inflation and augmented measures of employment, the Fed is still very much attuned to asset prices and will adjust its policy trajectory as necessary should market movements alter the macro outlook. And, of course, this reaction function is highly asymmetric; the Fed has in recent decades been quick to ease (or at least temper its tightening plans) when risk assets have faltered but has been slow to pursue restrictive policies in frothier environments.

Benchmark interest rates were often lifted during market pullbacks in the 1970s and 1980s when inflation concerns were predominant, but the spotlight on wealth effects in the 1990s and systemic risks in the wake of the Global Financial Crisis has given rise to a de facto braking mechanism within and in advance of monetary tightening cycles. The taper tantrum of eight years ago is a prime example. Fed Chair Ben Bernanke telegraphed a wind down of quantitative easing in congressional testimony in May 2013, saying that “we could in the next few meetings…take a step down in our pace of purchases”, but the actual taper would not come until the following year thanks in large part to the selloff in the Treasury market that those comments engendered. Similarly, the rate hikes that the Fed expected to initiate in early 2015 didn’t materialize until the tail end of that year due to an equity market correction that began in the spring (it is also telling that 2015’s lone rate hike came on the heels of a countertrend rally, with the S&P 500 climbing by 12.1 percent between late September and early November). It would come as little surprise should similar market ripples slow the transition into the next tightening cycle, as well. The markets may not be garnering the lion’s share of the central bank’s attention at the moment, but they are a good bet to be front and center when they eventually take a marked turn for the worse.

Daily Trivia

What was the FBI codename for the operation centered around the fictional Abdul Enterprises?

Previous Question

What company’s name and logo both reflect its San Francisco origins, the latter incorporating electromagnetic waves in the form of the Golden Gate Bridge?

Answer:

Cisco Systems

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