Rethinking the Fed: More Tightening than Priced In? Next Financial Crisis Coming Up?

by Mish Shedlock, Mish Talk: Time and time again, the Fed sows seeds of the next financial crisis in actions it takes to mitigate the previous financial crisis that it caused.

Have we reached that point yet?

The Guardian reports Central Banks Raise Alarm Over New Crash After Steep Rise in Lending.

Soaring stock markets, which have become detached from underlying values, were another sign that unjustified exuberance had replaced last year’s overly pessimistic reaction to political events such as the US election and the UK’s Brexit vote, BIS cautioned in its annual report published on Sunday.

Claudio Borio, the chief economist at the BIS, welcomed a turnaround in global growth over the past year that had “strengthened considerably and [was] forecast to return to long-term averages soon”.

He said: “Economic slack in the major economies has diminished further; in some, unemployment rates have fallen back to levels consistent with full employment. And inflation has moved closer to central bank objectives.”

But he warned that financial markets and policymakers were too quick to forget the risks that brought about the 2008 financial crash. The disconnect between the exuberance of stock market investors and bond investors who lend funds to nation states was also a destabilising factor.

“There is tension between stock markets, which have soared, and sovereign bond yields [the interest rate on the debt], which have not risen much as economic prospects have brightened. And, unfortunately, the unwelcome long-term developments we termed “the risky trinity” in last year’s report are still with us: unusually low productivity growth, unusually high debt, and unusually narrow room for policy manoeuvre,” Borio said.

“Leading indicators of financial distress point to financial booms that in a number of economies look qualitatively similar to those that preceded the great financial crash.”

Are We Safe From the Next Financial Crisis?

Commenting on the Guardian article, CTMfile asks Are we safe from the next financial crisis?

On the whole, the BIS annual report is a lot less alarmist than the Guardian article makes out. But there are others in the press and financial industry that are voicing concerns about problems up ahead in the global financial system.

Richard Bove of Rafferty Capital disagrees with Janet Yellen and writes that the next financial downturn could be far more devastating that the previous one and says that “The financial system is now at massive risk” because financial regulations now prevent the government from bailing out a struggling bank, meaning that the bank may have no choice but to fail. Bove argues that the very regulations put in place after 2008 could in fact be the destabilising factor that leads to the next big downturn.

Bove Ass Backward

Bove is correct about a potential crisis, but he has things ass backward.

We are in this mess because the Fed and governments have repeatedly bailed out banks on the moral hazard grounds known as “too big to fail”.

Dilemma of Transparency

The BIS Annual Report is lengthy but it’s worth a scan. Here are a few snips regarding the Fed’s communication tactics and balance sheet normalization.

The combination of gradualism and transparency raises a dilemma. It can certainly dampen volatility in the short run. But, if pushed too far, it may raise the risk of a larger adjustment and unwinding in the longer run.

This dilemma is especially visible in the context of balance sheet policies – how central banks decide to normalize the size and composition of their balance sheets.

The 2013 taper tantrum and the associated communication difficulties are still very much on policymakers’ minds.

Other, novel challenges have more of a political economy nature. Large central bank government bond purchases when rates are unusually low will entail losses precisely when the policy succeeds; that is, when the economy and inflation recover. The corresponding losses can lead to unwarranted public criticism and even threaten the central bank’s autonomy.

Similarly, large-scale central bank government bond purchases, financed mainly with excess reserves, amount to a sizeable quasi-debt management operation: they equate effectively to replacing long-term debt with very short-term claims, indexed to the overnight rate.

The normalization of monetary policy in the major economies also has implications well beyond their borders. Developments in the past decade have shown that monetary policy spillovers can pose complicated challenges for central banks and disrupt adjustments in the global economy.

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