Ex-RBI chief says markets are underestimating the Fed's resolve to fight inflation.
The Federal Reserve’s plan to reduce its USD8.8 trillion balance sheet carries significant risks, including a possible liquidity crunch in financial markets that would have broad repercussions for corporate credit, former Reserve Bank of India Governor Raghuram Rajan told MNI.
Rajan, who co-authored a paper on the subject presented at this year’s Jackson Hole conference, said in an interview the Fed is too complacent about the prospect that Treasury market liquidity will vanish in times of stress, as it did with the onset of Covid in March 2020.
“When you talk to Fed officials, there’s generally a sense that we solved that problem with these liquidity coverage ratios – this may have been yesterday’s problem, it’s not today’s problem,” said Rajan, a professor at the University of Chicago’s Booth School.
“Whenever I hear that I get worried because it does mean you put a lot of faith in your regulations dealing with the problem.”
Rajan said officials often blame episodes when liquidity dried up to minor regulatory issues when in fact they are more systemic and a direct result of the build-up of reserves that accompanied the central bank’s massive QE program.
“Demand deposits have gone up hugely in the system and if you look at credit lines, even various forms of guarantees of what corporations do, what hedge funds do, what other financial firms do, have gone up,” he said.
This could be a recipe for trouble if the economy enters a serious slump where concerns about the solvency of financial firms or other large corporations come into play.
“What we worry about is some combination of a real downturn when you start worrying about credit risks across the banking system, across the nonfinancial system, and liquidity being relatively scarce compared to the very increased demand for liquidity,” he said. “When these two come together you can get fairly unpleasant outcomes.”
He added that liquidity coverage ratios that are supposed to create a buffer against crises are not especially reliable.
“The liquidity coverage ratio ensures we have enough liquid assets to cover 30 days of runoff. But what is 30 days of run off? If they all run in one day that might be really problematic,” he said. (See MNI INTERVIEW: Fed's Mester Focused on QT Impact on Liquidity)
HARD LANDING RISKS
Turning to the Fed’s aggressive interest rate hikes this year, Rajan said the central bank still has a chance to ensure higher expectations of inflation do not become entrenched among businesses and consumers, but added the window is closing rapidly.
“The question is at what point do people say I just can’t make ends meet without a further increase in wages or compensation,” he said. “I don’t think we’ve reached that time yet, so in that sense expectations are still anchored. But if we stay with 8 to 9% for a substantial period of time, people will start saying those 3, 4, 5% wage increases are simply insufficient.”
Rajan said markets are likely underestimating not only how high interest rates need to go but also how long they need to stay high – and how much pain that will entail – in order to bring inflation that registered an 8.5% yearly gain in July back toward the Fed’s 2% target.
“I don’t think cutting interest rates is on the minds of any Fed policymakers and that was clearly indicated at Jackson Hole,” he said.
“They’re seared by the memory of the 70s – the Fed cut interest rates only to see inflation come back up. You have to wait to see that you’ve killed the beast, and that would mean inflation coming down significantly, even below the Fed policy rate by some amount.”
The most optimistic outcome, he said, would be for the Fed to hike rates somewhat above 4% and then wait for signs that inflation is coming down and the labor market is softening before a long pause, which would last at least through the end of 2023. And that could mean a much bigger hit to employment than officials – and inventors – currently expect.
“If you take the old view and you compute elasticities, sacrifice ratios, the numbers that come out are pretty alarming,” Rajan said. “To bring inflation down from these levels, even under optimistic scenarios, would require an unemployment rate of 2.5% more than we have now for a sustained period of two to three years.”