MNI INTERVIEW: Fed Has ‘Long Way To Go’ On Hikes-Acharya

The Federal Reserve is nowhere near finished raising interest rates and financial markets are not prepared for how tight monetary policy will need to get in order to bring down inflation, former Reserve Bank of India deputy governor Viral Acharya told MNI.

Investors may also be ignoring risks to the financial system posed by the process of reducing the central bank’s USD8.8 trillion balance sheet, said Acharya, who presented a paper on QT at the Fed’s Jackson Hole conference this year.

“The Fed rate hike cycle has a long way to go,” said Acharya, now a professor at New York University’s Stern School of Business, in an interview. “Even the professional investors have not yet internalized the full scale of rate hikes and tightening that will be needed if inflation doesn’t come down that quickly. And I think it’s not coming down that quickly.”

Acharya said that while market expectations for inflation remain relatively contained, household expectations of inflation have already drifted dangerously higher.

“Household expectations are not anchored – they are very adaptive they are based on realized inflation. The Fed needs to hike rates more precisely to bring expectations more in line with their policy path,” he said. (See MNI INTERVIEW: Fed Will Need To Hike Past 5% – Buiter)

Acharya did not specify a level for the terminal fed funds rate, but he suggested Fed talk of rates peaking at 4% was still far too optimistic.

“They will probably wait for a sustained three-to-six month period of declining inflation before they can really think about at what point do we slow down the pace of tightening,” he said, adding it’s too soon to say inflation has peaked.

“If the prints remain in the range of 8% they will have to keep up the pace of 75 basis points” per meeting, especially given the lagged effects of monetary policy.

LIQUIDITY MISMATCH

Acharya also pushed back against the dominant view within the Fed that the process of winding down the balance sheet will carry on in the background without major market disruptions.

“The Fed may have to strike a delicate balance as it embarks on this because the financial system also creates leverage, especially of the short-term type, in periods of easy money,” he said.

“Now when you contract liquidity, if these claims don’t contract at the same pace or more gracefully then you could have a bad intersection of declining liquidity assets and a large residue or stock of claims on liquid assets.”

These risks can materialize through three channels, Acharya said: commercial banks, shadow banks or a mix of both.

“The most problematic is the interaction of these two – if corporates have become reliant on bond markets and if they are not able to roll over costs that are very large, then they draw down on credit lines from banks,” he said.

“Some of the credit lines are in fact sold to asset managers, central counterparties, as well. So the drawdown on credit lines may not just be from nonfinancial corporations, they can even be from financial corporations, utilities, which also get stressed in a time of aggregate uncertainty.”