On May 6, the Federal Reserve Board issued its latest semi-annual “Financial Stability Report” cataloging the most important financial “vulnerabilities” that could trigger “widespread problems in times of stress.” It spans 73 pages but fails to identify the biggest risk to the economy and the financial sector: The Federal Reserve’s continued monetary expansion to fund proliferating government spending despite warning signs of rising inflation.
The Fed identifies four key vulnerabilities that magnify the risk of financial instability: overvalued assets, excessive borrowing by business and consumers, excess leverage in the non-bank financial sector, and excessive reliance on short-term funding.
The report reassures us that banks and bank holding companies regulated by the Fed are not a vulnerability: “Banks remain well-capitalized, and …[f]unding risks at domestic banks remain low” (page 8). Indeed, the vulnerabilities the report identifies are almost entirely associated with institutions the Fed does not currently regulate, including hedge funds, collateralized loan obligations, asset-backed securities, money market mutual funds, and other fixed-income mutual funds.
Stability risks include the rich valuations investors have assigned to stocks, corporate bonds, commercial real , and farmland. These asset prices could fall if “investor risk appetite fall[s], progress on containing the virus disappoint[s], or the recovery stall[s].” The Fed recognizes in passing the huge increase in home prices, but does not point to housing or mortgages as sources of vulnerability even though 5 percent of mortgages are past due, a large share of which are benefiting from waved penalties and interest-free loans on missed payments under government-mandated forbearance programs.
Like all government agencies, the Fed likely expects few will read a lengthy report, and even fewer will question its arguments. However, the stability report includes a number of “findings” that support the Fed’s preferred narrative but seem questionable upon inspection.
An example is the Fed’s discussion of financial-sector funding risk, or the risk that financial institutions may be unable to meet their funding needs in a financial crisis. The Fed contrasts funding risk in the banking system to funding risk for money-market mutual funds (MMFs) in a narrative designed to support the Fed’s push for bank-like regulations on the MMF industry.
In a crisis, the Fed reports that banks could face more than $8.4 trillion in withdrawals if uninsured depositors run and customers draw their bank lines of credit. Because banks hold liquid assets they can sell to raise the needed funds, the Fed finds this exposure unproblematic.
In contrast, the Fed points to MMFs as a stability concern because, in the face of shareholder redemptions, MMFs might have to liquidate $4.3 trillion in short-term debt securities at “fire sale” prices, which would disrupt financial markets.
You might wonder why the forced sale of $4.3 trillion in MMF assets would cause instability while the forced sale of $8.4 trillion in bank assets would not. The short answer is that the Fed willingly provides liquidity backstops to help fund banks through such a crisis but is reluctant to provide the same liquidity support to MMFs unless crisis conditions force its hand.
Banking institutions are mostly funded using borrowed money, 80 percent of which are deposits withdrawable on demand, including $6.85 trillion in uninsured deposits, most of which are at the largest banks. Uninsured deposits are the first to run in a financial crisis. When depositors run, a bank can sell its assets to meet withdrawal demands or pledge its assets as collateral at the Fed’s discount window to borrow needed funds.
MMFs are funded by shareholders, who receive a proportional share of the interest MMFs earn from investing in the short-term liabilities, like commercial paper, issued by corporations and sold directly to investors. In normal times, credit-worthy firms issue short-term debt instruments to raise working capital at terms and interest rates more favorable than those offered by banks. For investors, MMFs are a higher-yielding alternative to bank deposits.
Unlike banks, MMFs do not normally have access to the Federal Reserve’s discount window. However, in the past two financial crises the Fed was forced to make special liquidity programs available to MMFs that allowed MMFs to meet redemptions without selling assets under panic-stricken market conditions. The Fed was forced to provide this service to prevent the collapse of non-bank short-term funding markets that are critical for the economy.
Even these special programs successfully calmed investors and stemmed MMF withdrawals, the Fed abhors the idea of providing liquidity backstops to institutions it does not regulate, especially when the institutions are banks’ direct competitors. The Fed would rather shrink the MMF industry by pushing bank-like regulations instead of changing its lender-of-last resort practices to better serve the modern financial system.
The report’s boldest assertions appear when discussing the connection between low interest rates and elevated asset prices or correspondingly low risk premiums. You might be puzzled to learn that the Fed is not responsible for the low interest rates that are inflating asset prices.
Rather, “low interest rates tend to be driven by changes in the structure of the economy that reduce expected returns in many asset classes.” How presumptuous to think that a decade of near-zero Fed policy rates and the expansion of the Fed’s balance sheet to $7.8 trillion is responsible for the historically low interest rates.
The biggest vulnerability the Fed’s report leaves unidentified is the risk of inflation. While the Fed highlights risks associated with asset market valuations predicated on expectations of a Goldilocks COVID recovery, it avoids mentioning that the return of high single-digit sustained inflation would increase long-term interest rates and deflate asset prices as readily as a stalled recovery. And sustained inflation is a real risk given the Fed’s embrace of modern monetary theory and its monetization of out-of-control government spending.
According to Bureau of Labor Statistics data, between February and April 2020, at peak unemployment during the COVID recession, 17.3 million jobs were lost. In 2020, the CARES Act added $260 billion in enhanced unemployment benefits, a Pay Check Protection Program (PPP) that ultimately provided nearly $700 billion in small business grants (administered as forgivable loans), and authorized $376 billion in stimulus checks of $1,400 for individuals in nearly 160 million households.
In April 2020, the first round of CARES Act stimulus checks resulted in a 10.5 percent increase in personal income. Despite a recession that reduced 2020 nominal GDP by 2.3 percent, one estimate suggests that, because of federal transfers, median household income rose more than 8.5 percent.
Through the end of 2020, households used stimulus checks and cash freed-up by federal mortgage and rent forbearance mandates to pay down credit card and auto loan balances and increase their savings. The Fed reports that in the second half of 2020, household cash and checkable deposits doubled to $3 trillion.
As the economy opens in 2021 and COVID fears recede, these balances are likely be used to purchase goods and services in an economy where production is hampered by supply-chain and labor shortages. It appears to be a classic case of too much money chasing too few goods.
But the spending did not stop in 2020. In late December, the Consolidated Appropriations Act of 2021 added new stimulus payments of $600 per adult, $300 per month in federal unemployment supplemental benefits, and new funding for PPP.
In March 2021, President Biden signed another $1.9 trillion spending package that includes $1,400 in additional stimulus checks to most American adults and extends $300 monthly supplemental unemployment payments until September 2021. Thus far, all in, the government has spent $6 trillion, or almost $42,000 per taxpayer, on COVID-labeled increased spending.
While the Fed may not admit it, a surge in inflation is likely the biggest threat to financial stability. If a spike in inflation causes investors to revise their long-term inflation expectations, asset prices will fall, business and government borrowing costs will increase, federal budget deficits will explode, and banks, including the Fed, will face a scenario in which rising short-term finding costs exceed the yields on their longer-maturity legacy loan and securities portfolios.
In assessing financial stability risks, the Fed should look into a mirror.