MNI INSIGHT: Fed Sees Fin. Stability As Separate From Rates

There is no sign the Federal Reserve will hesitate to keep raising interest rates despite financial disruptions caused in part by its aggressive monetary tightening, even as officials keep a close eye on market function and possible contagion from volatility in UK gilts.

Speculation is rife that recent market turmoil could force the Fed to reconsider its resolve to keep raising interest rates, after three consecutive 75 basis point increases and with another expected next month.

Yet Fed policymakers are convinced that the U.S. banking system is much stronger and resilient than it was ahead of the global financial crisis of 2007-2009. And they see tighter financial conditions as a part of the goal of intense monetary policy actions, not a negative side-effect to be suppressed.

Their comments indicate that it would take a truly systemic event, like a March 2020-style seizure of the Treasury market or a liquidity crunch in the corporate sector that has cascading contagion effects, for the Fed to react and even then it would avoid using monetary policy tools, especially interest rates, to do so.

Treasury market liquidity has been challenged in recent weeks, a fact acknowledged by New York Fed President John Williams. But Fed Governor Chris Waller pushed back last week against worries that any market seizure might be at hand, citing huge holdings in the Fed’s reverse repo facility. (See: MNI: Fed To Press Ahead With QT Amid Liquidity Concerns)

"The markets are handing us USD2.2 trillion worth of liquidity that they don't need. So I have a hard time believing that I need to step in and do something on liquidity concerns,” he said.

UNPRECEDENTED SPEED OF TIGHTENING

The nearly unprecedented speed of Fed tightening, which includes not just rate rises but also balance sheet runoffs or QT, is squeezing markets around the world as currencies slide against a rapidly rising dollar and credit markets that had become accustomed to permanently low rates are forced to adjust quickly.

Yet the central bank, seeing this as part of the necessary cost to bring inflation down from near 40-year highs, could keep hiking rates even if there were market dysfunction, officials indicate. Cleveland Fed President Loretta Mester says there’s a major distinction between monetary policy and ensuring markets don’t seize up.

“The mechanism through which monetary policy affects the economy is through financial conditions. I would distinguish that from market functioning. The reason the Bank of England stepped in it was about real market functioning that wasn’t about monetary policy,” she said.

“I have not seen any evidence that markets aren’t working in the U.S. Yes, financial conditions are tightening but that’s the mechanism through which demand is going to moderate.”