By Lance Roberts
Market instability is the biggest risk to central banks globally, replacing inflation, owing to massive amounts of leverage.
So far, the U.S. Federal Reserve is fortunate because there’s low volatility in the stock market /zigman2/quotes/210599714/realtime SPX -0.12% , even though there’s a bear market. Market stability affords the Fed the space needed for the most aggressive rate-hiking campaign since the late 1970s.
However, stable markets can become unstable rapidly when something breaks due to rising rates or volatility. The Bank of England (BOE) is a current example of what happens when things go awry. The BOE on Wednesday was forced to start buying bonds to solve a potential crisis with U.K. pension funds . The pension funds receive margin when yields fall and post additional collateral when yields rise.
As they have recently, the pension funds are hit with margin calls, which have the potential to cause market instability. Due to leverage built up through the financial system, market instability can spread like a virus through global markets. That’s what happened in 2008 with the Lehman crisis.
Is the BOE’s actions an isolated event, or will the Fed be the next central bank to reverse its monetary policy?
The Federal Reserve said it’s deeply committed to its aggressive campaign to quell surging inflation. As Chairman Jerome Powell said at the Jackson Hole Summit in August:
“[A] failure to restore price stability would mean far greater pain.”
Still, the Fed doesn’t want to cause a recession. That may be a challenge for two reasons:
The Fed remains focused on lagging economic data, such as employment, which are highly subject to future revisions.
Therefore, as the Fed is hiking rates based on lagging economic data, the risk of a policy mistake becomes heightened. By the time economic data deteriorate, the preceding rate hikes have yet to impact the economy, which eventually deepens the recession.
As shown, the annual rate of change of the fed funds rate is now at a record. However, every previous rate-hiking campaign has led to a recession, bear market or other economic event.
Remember, the Federal Reserve does not operate in an economic vacuum. Other factors contribute to the tightening of monetary policy and the impact on economic growth. When those other factors, such as higher interest rates, falling asset prices or a surging dollar, coincide with the Fed’s policy campaign, the risk of “market instability” increases.
Policy mistake in the making
The current bout of inflation is vastly different than that of the late 1970s.
Economist Milton Friedman once said that companies don’t cause inflation; governments create inflation by printing money. There was no better example of this than the massive government interventions in 2020 and 2021 that sent subsequent rounds of checks to households, creating demand, when an economic shutdown constrained supply due to the pandemic.