Nov 22, 2022, 9:58 AM ETInterview, Fireside Chat, Other

Central bank tightening: what could break?

Inflation as Primary Mandate: Jeremy Stein (former Fed Governor) asserts that with inflation "far from the mandate," the Federal Reserve's only viable option is to prioritize taming inflation over preemptively addressing potential financial instability risks.
- Stein argues that pulling back on inflation fighting due to "unknown possible financial breakage" is unwarranted until actual risks manifest.
- He contrasts the current high-inflation environment with late 2019 (unemployment 3.5%, inflation 1.7%), where financial stability considerations would have outweighed the drive to raise inflation to the 2% target.
ECB Policy Divergence: Vitor Constancio (former ECB Vice President) maintains that monetary policy should not serve multiple objectives (inflation, economy, financial stability) simultaneously.
- He argues central banks require distinct instrument sets: traditional monetary policy for prices and macroprudential tools for financial stability cycles.
- Constraint: Constancio notes that macroprudential buffers often do not exist or were not built during the pandemic, forcing a "reluctant" reliance on interest rates for stability if necessary.
- Historical Shift: He highlights that while he opposed 2018 proposals to use rates for asset prices, the ECB's 2021 strategy adopted financial stability considerations, creating a paradox where rates are now needed up to fight inflation, potentially complicating stability management.

QT as Rate Hike Equivalent: Lyle Brainard (former Fed VP) quantified that the full QT program is equivalent to a 200–300 basis point rate increase; Constancio warns this exacerbates financial fragmentation risks in the Euro Area's heterogeneous monetary union.
TLTRO Early Repayment: The ECB changed conditions on Long-Term Refinancing Operations (TLTROs), creating an expectation that banks may repay 1.2 trillion in borrowed funds before maturity (originally due June next year), effectively shrinking the central bank balance sheet prematurely.
- Constancio urges the ECB to proceed with QT very gradually to avoid triggering instability.
Sovereign Bond Liquidity Fragility:
- US Market: Treasury Secretary Yellen publicly acknowledged concerns over Treasury market liquidity; structural issues include insufficient broker-dealer capacity to manage the enlarged market size compared to 2020.
- Potential Trigger: Stein suggests the Federal Reserve expand access to its standing repo facility beyond banks and dealers to include hedge funds and mutual funds, preventing forced fire sales during stress.
Open-End Bond Fund Vulnerabilities:
- High mismatch between asset and liability sides in open-end funds increases the risk of fire sales if redemption pressures arise.
- Stein notes the 2020 Fed bailouts created "moral hazard," potentially obscuring the true fragility of these funds from market participants.

Euro Area Inflation Structure: Europe faces a more complex inflationary environment than the US, with 69% of total inflation driven by energy and food (vs. 38% in the US), making deceleration slower due to persistent external price shocks.
- Core inflation contributions are 62% in the US compared to 34% in Europe.
High Yield and Leveraged Loans: Rising interest rates and anticipated recessions are expected to trigger default risks in firms holding high-yield bonds and leveraged loans.
China's Economic Risks:
- Growth deceleration and a potential collapse in the Chinese housing market bubble present a distinct source of global instability.
Emerging Market Defaults: Expected defaults in emerging economies may strain global banking systems through overexposure, though the systemic impact remains uncertain.
Currency and Sovereign Debt Spillovers:
- Dollar Strength: A sharply appreciating US dollar pressures emerging markets with dollar-denominated corporate debt.
- Japan: With debt-to-GDP exceeding 200% and most debt rollover-dependent, rising global rates could destabilize Japan's fiscal picture by forcing higher interest costs on sovereign debt.

Constrained Crisis Response: Stein warns that the Federal Reserve's ability to intervene is more limited than in 2020; fiscal backing (like the CARES Act SPVs) may not be available to purchase corporate bonds or provide credit facilities.
- Communication Challenge: In an inflationary environment, the Fed faces a difficult communication task distinguishing "market function" Treasury purchases from monetary easing (QE).
The End of the "Fed Put": Markets may not fully grasp that the Fed is less likely to deploy aggressive liquidity measures during credit events now that inflation is the primary focus; the realization of a reduced "Fed put" could amplify the impact of initial defaults.
Rate Hike Expectations: Constancio predicts the current tightening cycle will end before severe financial instability materializes, with markets forecasting peak rates around 5% for the Fed and 3% for the ECB.
- He views significant instability as a risk only if rates rise well beyond these expected peaks.
Unrealized Risks: Stein observes that despite aggressive tightening, the market remains orderly ("no drop of blood has yet been spilled"), but warns that the most significant financial cracks often occur when policy begins to materially slow the economy.