A sharp rise in interest rates to tame new inflation shocks would pose a risk to the US economy, the Federal Reserve said Monday, reporting a “greater than normal” chance that trading conditions in US financial markets would deteriorate sharply.
“Further negative surprises in inflation and interest rates, especially if accompanied by a decline in economic activity, could negatively affect the financial system,” policymakers wrote in the Fed’s Financial Stability Report, 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, and businesses are also facing “greater delinquency, bankruptcies and other forms of financial hardship.”
“A sharp rise in interest rates could lead to higher volatility, stress on market liquidity and large price adjustments for risky assets, which could potentially cause losses for a number of financial intermediaries,” the Fed reported.
That would reduce “their ability to raise capital and maintain the trust of their associates,” the central bank added.
The U.S. has also issued a liquidity warning – the ability to buy or sell assets without affecting price – after several crazy months in U.S. markets. The sell-off erased trillions of dollars from the value of stocks and bonds, while closing the door to new stock lists and increasing borrowing costs for consumers and corporations.
The Fed said the ability to buy or sell assets at prices quoted by broker dealers has “deteriorated” and is worse than would be expected given volatility levels. He added that the drop in liquidity could be exacerbated because brokers and high-frequency trading companies are “especially cautious” given market conditions.
“Reducing depth in moments of growing uncertainty and volatility could result in negative feedback, as lower liquidity in turn can cause price volatility,” policymakers wrote in the report.
Conditions in the treasury, commodity and stock markets were noticeably poor this year, and traders reported having difficulty conducting even relatively small trade without affecting prices.
Oscillations in the price of everything from government bonds to corporate bonds and stocks have also been driven in part by the Fed’s move to tighten monetary policy, as well as Russia’s invasion of Ukraine and China’s economic slowdown.
The central bank achieved its first half-point rate increase since 2000 last week and plans to make additional increases of the same magnitude at its next two policy meetings. It will also begin cutting its $ 9 billion balance sheet in June – which rose after raising bonds during the coronavirus pandemic – as it intensifies its efforts to curb high inflation in about 40 years.
The possibility of higher interest rates has pushed yields on the reference 10-year treasury to the highest level since 2018. That rise has forced investors around the world to reassess the value of many stocks they offered at record highs last year, with the S&P 500 it fell more than 16 percent this year, and the tech-heavy Nasdaq Composite fell more than 25 percent.
The Fed also highlighted the potential risks associated with the “prolonged” war between Russia and Ukraine, which has already burdened commodity markets.
“Russia’s unprovoked war in Ukraine has caused large price movements and margins in the commodity market and highlighted a potential channel through which large financial institutions could be exposed to the contagion,” Lael Brainard, vice president, said in a statement on Monday.
“The Federal Reserve is working with domestic and international regulators to better understand the exposure of commodity market participants and their links to the underlying financial system.”