Interest rates

Fed warns sharply higher interest rates could trigger financial distress

The U.S. Federal Reserve has warned of the potential for financial distress hurting the economy if interest rates rise to higher than expected levels, in a report that highlights stakes in its drive to control inflation tenacious.

The central bank’s latest financial stability report released on Friday highlighted a constellation of risks including a weaker global economy, “unacceptably high” inflation and geopolitical unrest. These currents have amplified the volatility of certain asset classes.

The report came two days after the Fed raised benchmark interest rates by 0.75 percentage point for the fourth consecutive time, bringing them down to a new target range of 3.75% to 4%. As recently as March, rates were hovering around zero. The Bank of England also raised rates by 0.75 percentage points on Thursday, as the European Central Bank also opted for a giant rate hike last week.

The Fed is raising rates in an attempt to cool an economy marked by persistently high inflation. If they were to rise more than expected, it would “weaken the debt-servicing capacity of households and businesses and lead to an increase in delinquencies, bankruptcies and other forms of financial distress”, according to its Financial Stability Report. .

The Fed added that this could eventually lead to increased market volatility, tight liquidity and further declines in asset prices, including in housing.

“Such effects could lead to losses among various financial intermediaries, reducing their access to capital and increasing their funding costs, with other adverse consequences for asset prices, credit availability and the economy,” the report said. , which is published twice a year. .

Lael Brainard, vice chair of the Fed, in a separate statement on Friday, pointed to the volatility that has engulfed some financial markets over the past six months, and stressed that the central bank would be “watchful” for financial stability risks.

“The current environment of rapid and synchronous global monetary policy tightening, high inflation and high uncertainty associated with the pandemic and war [in Ukraine] increases the risk that a shock could lead to the amplification of vulnerabilities, for example due to tight liquidity in major financial markets or hidden leverage,” she said.

A series of rapid interest rate hikes, followed by a possible recession, raised fears of an unintended market collapse, especially given the tight liquidity conditions. The Fed said there were signs that defaults on new home mortgages were increasing and downgrades in the corporate sector had accelerated.

However, the Fed noted that leverage within the US banking system remained relatively low and that major banks were well capitalized to absorb shocks “even during a significant economic downturn.” Systemically important banks have begun to reduce risk on their balance sheets, the Fed added, and their vulnerability to credit losses appears “moderate.”

Banks struggled to offload risky loans they had taken out over the past year before financial markets fell in value, holding tens of billions of dollars in deals such as the takeover of Twitter, software maker Citrix and television ratings group Nielsen. This has hampered their ability to lend to other large companies with low ratings.

While banks and brokers have largely profited from their trading operations this year, supported by violent swings in financial markets, the recent chaos in the UK sovereign bond market has raised concerns among policymakers.

The sell-off in gilts provided a glimpse of how quickly turbulence in one corner of the market can spread. Volatility spread to US credit markets as UK pension funds sold parts of their portfolios to meet large margin calls.

The Fed noted that volatility stemming from foreign risks, including those related to China and the war in Ukraine, could “pose risks for institutions that hedge dollar positions and for the functioning of the market,” as well as present problems for emerging markets that have borrowed in dollars.

“Continued or more extreme market volatility could contribute to liquidity stress that manifests unexpectedly,” the Fed wrote. “Structural vulnerabilities” in short-term funding markets could further amplify the problem.