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January 17, 2023

Federal Reserve Policies and Systemic Instability: Decoupling Asset Pricing from Underlying Risks

Dennis Kelleher, Cofounder, President, and CEO; Phillip Basil, Director of Banking Policy

While most of the current focus on the Federal Reserve (“Fed”) is around inflation and the Fed’s fight against it, the big missing story is how the Fed’s actions over the last 14 years have created many of the most significant risks and issues we face today. The Fed’s actions since the 2008 global financial crisis—including zero/near-zero rates and massive asset purchases – decoupled asset pricing from risk and ignited an historic borrowing and debt binge. The result is a set of risks that threaten to dramatically unwind and have devastating consequences.

Our report reviews how we got here, the risk implications of the Fed’s prior actions, and what the Fed must do to prevent making similar mistakes in the future.

Fed Actions Caused Risk Mispricing and Debt Buildup by Making Credit Unusually Cheap and Incentivizing Indiscriminate Risk Taking

The federal funds rate was near zero for nine of the last 14 years and, until around mid-2022, otherwise at historic lows. Asset purchases intended to depress longer-term rates (so-called “Quantitative Easing”) expanded the Fed’s balance sheet nearly five times to $4.4 trillion prior to the 2020 Pandemic, after which it added an astonishing $4.5 trillion more, almost doubling its balance sheet again to a shocking $8.9 trillion.

As a result, growth in nonfinancial corporate credit and consumer credit (excluding mortgages) between the 2008 Crash and 2020 Pandemic were 90% and 30% larger, respectively, than their growth prior to the 2008 Crash. In just the last two and a half years they have grown a shocking 10%. Additionally, with massive floods of liquidity, the “risk per dollar” that is reflected by credit spreads significantly decreased regardless of actual underlying risks, with spreads for the riskiest companies reaching a low in 2021 not seen since 2007 and debt issuance for them reaching well beyond historic highs.

The Fed Ignored the Adverse Effects and Warning Signs of Its Policies

The Fed was so focused on keeping its monetary policy actions “accommodative” and on short-term financial market conditions, it ignored the medium- and longer-term adverse effects of its policy actions as well as multiple warning signs in the analysis of how long and to what level its actions should proceed. For example, the Fed continued its immense asset purchases until March 2022—two full years after the 2020 Pandemic—even as year-over-year inflation soared past 8%. Put simply, there was no margin for error.

The Risks from the Fed’s Inflation-Related Policy U-Turn Are Rising

Now with the Fed moving quickly and forcefully in the opposite direction by raising rates and reducing its balance sheet, risk is being repriced, and asset prices have been collapsing. Credit spreads on the riskiest bonds as well as many creditworthy bonds increased around 50% just last year, causing significant market value losses and making it much more difficult for companies to obtain credit. As this continues and years of mispriced risk and unchecked leverage unwind, defaults will likely increase, potentially setting off contagion and undermining financial stability.

Looking Ahead the Fed Must Avoid Past Mistakes

Over the last 14 years the Fed ignored some of its own basic risk management principles and allowed significant risks to build. It gave far too little attention to the entrenchment of expectations around its ultra-accommodative policies among financial markets, businesses, and consumers, and it simply failed to see – or didn’t look or consider — itself as a potential source of risks. Without undertaking a thorough assessment of the Fed actions, we risk repeating the same mistakes and putting the U.S. in a series of highly abnormal boom-and-bust cycles that are almost entirely driven by monetary policy. Such a cycle must be avoided for the benefit of our economy and the livelihoods of all Americans.

Learn more in our full report here.



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