Fed warns sharp rise in interest rates poses risk to US economy

A sharp rise in interest rates to tame further inflationary shocks would pose a risk to the U.S. economy, the Federal Reserve said on Monday, citing a “higher than normal” likelihood that business conditions in the markets US financials suddenly deteriorate.

“Further adverse inflation and interest rate surprises, particularly if accompanied by a decline in economic activity, could adversely affect the financial system,” the policymakers wrote in the report on the Fed’s financial stability, published twice a year in May and November.

Consumer finances could be hit by job losses, higher interest rates and lower house prices, the Fed warned, with businesses also facing “higher delinquencies, bankruptcies and other forms of financial distress”.

“A sharp rise in interest rates could lead to increased volatility, strain on market liquidity and a sharp correction in prices of risky assets, potentially leading to losses at various financial intermediaries,” the Fed reported.

This would reduce “their ability to raise capital and retain the confidence of their counterparties,” the central bank added.

The United States also issued a liquidity warning – the ability to buy or sell an asset without influencing the price – after several frantic months in US markets. A sell-off wiped trillions of dollars off the value of stocks and bonds while closing the door to new stock listings and raising borrowing costs for consumers and businesses.

The Fed said the ability to buy or sell assets at prices quoted by brokers had “deteriorated” and was worse than expected given volatility levels. He added that the decline in liquidity could be compounded by the fact that brokers and high-frequency trading firms “are particularly cautious” given market conditions.

“The decline in depth during times of increasing uncertainty and volatility could lead to a negative feedback loop, as lower liquidity in turn can make prices more volatile,” the policymakers wrote in the report.

Conditions in the Treasury, commodities and equity markets have been noticeably poor this year, with traders reporting they have struggled to make even relatively small trades without influencing prices.

Fluctuations in the price of everything from Treasuries to corporate bonds and stocks have also been driven in part by the Fed’s decision to tighten monetary policy, as well as Russia’s invasion of Ukraine. and the economic slowdown in China.

The central bank last week announced its first half-point rate hike since 2000 and is expected to implement additional increases of the same magnitude at its next two policy meetings. In June, it will also start trimming its $9 billion balance sheet – which has swelled after sucking up bonds during the coronavirus pandemic – as it steps up efforts to contain the highest inflation in about 40 years.

The prospect of higher interest rates pushed the yield on the benchmark 10-year Treasury note to its highest level since 2018. This rise has forced investors around the world to reassess the value of many of the stocks that they have offered at record levels in the past. year, with the S&P 500 stock index down more than 16% this year and the tech-heavy Nasdaq Composite down more than 25%.

The Fed also flagged potential risks associated with a “protracted” war between Russia and Ukraine, which has already strained commodity markets.

“Russia’s unprovoked war in Ukraine has triggered large price moves and margin calls in the commodities market and highlighted a potential channel through which large financial institutions could be exposed to contagion” , said Lael Brainard, vice president, in a statement accompanying the report on Monday.

“The Federal Reserve is working with domestic and international regulators to better understand the exposures of commodity market participants and their connections to the core financial system.”

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