The Federal Reserve ignores the biggest risk to the economy

The Federal Reserve issues a financial stability report twice a year that assesses the resilience of the financial system and highlights near-term risks.

Is the Fed failing to see the biggest risk?

As the report says,

“In an unstable financial system, adverse events are more likely to result in severe financial stress and disrupt the flow of credit, leading to high unemployment and great financial hardship.”

Well, no kidding! But it is remarkable that central banks have been unable to ensure stability or even provide a warning when instability could lead to market crashes. The most recent example was 2008 when the Fed was reassuring everybody that the system was stable, up until the day when Lehman Brothers collapsed in September 2008, and for some time after. The Fed did act eventually, after it became clear that a global financial crisis had started. The Fed cut rates to zero by year-end.

In the months leading up to the crisis the Fed did not give any strong warning of a change in the conditions of the economy. In fact, during the run-up to Lehman Brothers collapse, the Fed kept interest rates at 2 percent, unaware of the dangers in housing, mortgages and speculation in derivatives.

In the transcript of the September 16 meeting (held the day after Lehman Brothers failed), there were 129 mentions of “inflation” and only 5 of “recession”. According to the NY Times article on February 21, 2014, most Federal Reserve officials still believed the economy would keep growing.

The Fed voted unanimously against cutting rates, and there were positive comments about letting Lehman Brothers fail.

Fast forward to today and we see a Fed that is highlighting some serious risks, such as a real estate crisis in China, but ignoring signs that inflation could be out of control in the U.S.

In the November 2021 report the Fed identifies several near-term risks, including “asset valuations are high relative to history”, “a sharp rise in interest rates” could lead to stresses at financial institutions, and “stresses in China’s real estate sector” could hurt China and spillover to the U.S.

But no mention of elevated inflation and how that might trigger a collapse in asset prices, for example.

The Fed surveyed people working in financial markets, and they identified “persistent inflation” as the top risk.

I checked for the word “inflation” in the 85-page document. There were six mentions only, and the one time “inflation” was highlighted as a near-term risk was in the responses to the survey. Not once was inflation mentioned in the risks identified by the Fed.

The concern about a sharp rise in interest rates is the second risk mentioned, but there is no discussion of the connection between higher inflation and higher interest rates.

This is extraordinary as the media are full of mentions of inflation and there is widespread concern over gas and food prices.

The Fed might be making a mistake that will surpass its complacency in 2008.

 

Hilliard MacBeth

 

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