Opinion: Market instability is replacing inflation as the main risk and increasing the likelihood of a retaliation by the Federal Reserve

Market instability is the biggest risk facing central banks around the world, replacing inflation due to massive leverage.

So far the US Federal Reserve has been lucky because the SPX stock market shows low volatility.
-1.51%,
although there is a bear market. Market stability is giving the Fed the leeway it needs for its most aggressive rate hike campaign since the late 1970s.

However, stable markets can quickly become unstable if something collapses due to rising interest rates or volatility. The Bank of England (BOE) is a recent example of what happens when things go wrong. The BOE was forced to start buying bonds on Wednesday in a bid to resolve a potential crisis involving UK pension funds. The pension funds receive a margin when returns fall and deposit additional collateral when returns rise.

As of late, pension funds are being plagued by margin calls that have the potential to cause market instability. Due to the leverage created by the financial system, market instability can spread like a virus through global markets. This is 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 monetary policy?

recession is imminent

The Federal Reserve said it was deeply committed to its aggressive campaign to quell rising inflation. As Chairman Jerome Powell said at the Jackson Hole Summit in August:

“[A] Failure to restore price stability would mean far greater pain.”

Nevertheless, the Fed does not want to trigger a recession. This can be a challenge for two reasons:

  1. The Fed remains focused on lagging economic data such as employment, which is highly subject to future revisions.

  2. Changes in monetary policy only become noticeable in the economy nine to twelve months in the future.

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Therefore, as the Fed hikes rates on the back of lagging economic data, the risk of a policy error increases. Until economic data worsens, the previous rate hikes have yet to have an impact on the economy, eventually deepening the recession.

As shown, the annual rate of change in the fed funds rate is now at record levels. However, every previous rate hike campaign has resulted in a recession, bear market, or other economic event.

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Remember, the Federal Reserve does not operate in an economic vacuum. Other factors are contributing to the tightening of monetary policy and the impact on economic growth. When these other factors, such as higher interest rates, falling asset prices, or a rising dollar, coincide with the Fed’s policy campaign, the risk of “market instability” increases.

Political error in manufacturing

The current wave of inflation is very different from that of the late 1970s.

Economist Milton Friedman once said that corporations don’t cause inflation; Governments create inflation by printing money. There was no better example of this than the massive government interventions of 2020 and 2021, sending more rounds of checks to households and creating demand when an economic shutdown curtailed supply due to the pandemic.

The following figure is taught in every Economics 101. Unsurprisingly, when supply is constrained and demand increases as a result of the provision of stimulus checks, inflation results.

As the Fed sees some lagging economic data, forecasts for inflation are falling fast. That’s because the economy is faltering as liquidity dries up.

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Historically, high prices are the best cure for high prices, as the saying goes. In other words, inflation would resolve itself as high costs constrain consumption.

But the financial system is complex. Interest rates and the dollar have risen dramatically in recent months, adding further downward economic pressure from rising domestic and global costs. Not surprisingly, sharp annual gains in the dollar have been accompanied by market instability and economic fallout.

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In addition, the rise in the dollar, fueled by higher interest rates, has been accompanied by the sharpest rise in interest rates in history. This is problematic, especially in highly indebted economies as debt service and borrowing costs rise. Interest rates alone can destabilize an economy, but when combined with a rising dollar and inflation, the risks of market instability increase significantly.

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The Fed will blink

After more than 12 years of the most unprecedented monetary policy program in history, the Federal Reserve has put itself in a bad spot. Policymakers risk spiraling inflation unless they raise interest rates to quell inflation. When the Fed raises interest rates to fight inflation, the risk of recession and market instability increases.

The behavioral biases of individuals remain the greatest risk facing the Fed. For now, investors haven’t “pressed the big red button,” giving the Fed room to hike rates. However, the BOE discovered that when “something breaks” market instability quickly emerges.

When will the Fed find the limits of its monetary policy interventions? We don’t know, but we suspect they’ve already passed the point of no return, and history is an excellent guide to the negative consequences.

  • In the early 1970s, it was the Nifty Fifty stocks.

  • Then, a few years later, Mexican and Argentine bonds.

  • “Portfolio insurance” was the “thing” in the mid-1980s.

  • Dot.com-anything was an excellent investment in 1999.

  • Real estate has been a boom/bust cycle about every two decades, but 2007 was a sucker.

  • Today it’s real estate, FAANNGT, debt, credit, private equity, SPACs, IPOs, “meme” stocks – “everything.”

For the Federal Reserve, inflation is the enemy it must defeat. But while high inflation is detrimental to economic growth, market instability is far more insidious. That’s why the Fed rushed to bail out banks in 2008.

Unfortunately, we doubt the Fed has the stomach for “market instability”. As such, we doubt they will hike rates as much as the market is currently anticipating.

Lance Roberts is Chief Strategist at RIA Advisors, Editor of Real Investment Advice and Host of The Real Investment Hour.

https://www.marketwatch.com/story/market-instability-replaces-inflation-as-the-biggest-risk-raising-the-chances-of-a-pivot-by-the-federal-reserve-11664471363?rss=1&siteid=rss Opinion: Market instability is replacing inflation as the main risk and increasing the likelihood of a retaliation by the Federal Reserve

Brian Lowry

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