By Rich Miller
The Federal Reserve hasn’t had much success so far in wrestling down sky-high inflation, but its monetary tightening campaign is having a major impact in deflating asset bubbles that swelled during the pandemic.
- The cryptocurrency market — once valued at $3 trillion — has shrunk by more than two-thirds
- Investor-favored technology stocks have tumbled by more than 50%
- Red-hot housing prices are falling for the first time in 10 years
Most importantly – and surprisingly – all this is occurring without upending the financial system.
“It’s astonishing,” said Harvard University professor Jeremy Stein, who as a Fed governor from 2012 to 2014 paid special attention to financial stability issues. “If you told any one of us a year ago, ‘we’re going to have a bunch of 75 basis-point hikes,’ you’d have said, ‘Are you nuts? You’re going to blow up the financial system.’”
Fed policymakers have long shied away from using monetary policy to address asset bubbles, saying interest-rate hikes are too blunt a tool for such a mission. But the current deflation in asset prices could help achieve the soft landing in the economy Chair Jerome Powell and his colleagues are seeking.
A broader financial blowup can’t be ruled out. But the current episode for now marks a sharp contrast with the bursting of the US property-price bubble that triggered a deep downturn from 2007 to 2009, and the tech-stock meltdown that helped push the economy into a mild recession in 2001.
Partly in recognition of the risks – and the fact they’ve already raised interest rates a lot – Powell & Co. are primed to throttle back rate increases to 50 basis points next week, after four straight 75 basis-point moves.
Here’s how their campaign has helped affect asset markets so far:
Housing Cooldown, Not Meltdown
Ultra-low borrowing costs, along with a surge in demand for properties outside of urban centers during the pandemic, saw housing prices soar. Those are now coming down under the weight of a more-than-doubling in mortgage rates this year.
Financial reforms instituted after the financial crisis helped ensure that the latest housing cycle didn’t feature the kinds of loosening in credit standards seen in the early 2000s. The so-called Dodd-Frank measures have left banks much better capitalized, and much less leveraged than they were back then.
Banks are also awash in deposits, courtesy of the excess savings that Americans built up while holed up during the pandemic, said Wrightson ICAP LLC chief economist Lou Crandall.
“This housing downturn is different from the 2008 crash,” Bloomberg chief US economist Anna Wong and colleague Eliza Winger said in a note. Mortgage credit quality is higher than it was then, they wrote.
While nonbank lenders – so-called shadow banks – have become a massive new source of credit in US housing in recent years, the mortgage market still has an effective backstop in the form of the nationalized financiers Fannie Mae and Freddie Mac.
“Maybe we shouldn’t be surprised that housing isn’t more disruptive to the financial system — because we federalized it,” said former Fed official Vincent Reinhart, now chief economist at Dreyfus and Mellon.
Crypto Collapse, Contained
Much of the speculative excess seen during the pandemic was centered on crypto. Luckily for the Fed and other regulators, that’s proved to be largely a self-enclosed ecosystem with the firms inside it mostly indebted to each other. A broader integration with the financial system might have made the downturn much more destabilizing.
“It wasn’t providing any services to the traditional financial system or the real economy,” said former Bank for International Settlements chief economist and Brandeis University professor Stephen Cecchetti, who likened the crypto market to a multiplayer online video game.
So yes, many players in the market have been hurt by the crypto crack-up, but the fallout elsewhere has been minimal.
Tech Tumble, But No Dot-Com Bust
Stocks of technology-sector firms that prospered during the era of pandemic lockdowns have also plunged, wiping out trillions of dollars in market capitalization. But the decline has been gradual, spread out over the course of the last year as Fed rates marched higher.
And the losses, while large, are a fraction of the scale seen in the bursting of the tech bubble at the start of the century. The Nasdaq Composite Index is down a little over 30% from its high reached last year, but that compares with an almost 80% crash two decades ago.
The broader stock market has held up even better, with the S&P 500 Index about 18% off of its record high hit in January.
“By and large equities aren’t leveraged,” Cecchetti said. “And the people that own them tend to be pretty well off.”
No All-Clear
The full financial fallout from the Fed’s inflation-fighting crusade may not be evident quite yet. Not only are more rate hikes in the pipeline, but the central bank continues to shrink its balance sheet, through so-called quantitative tightening. The only other time the Fed conducted QT, it had to end the process sooner than expected, following bouts of market volatility.
Shocks can occur suddenly, as the recent blowup in the UK bond market showed, auguring caution. And policymakers don’t have as much information as they’d like about what’s going on in the less-regulated shadow banking arena.
“That’s a problem,” former Fed Chair Ben Bernanke said in a lecture in Stockholm on Thursday marking his receipt of the Nobel Prize in Economics. While there’s been some increased regulation of the shadow banks, it’s “not nearly enough.”
One continuing source of worry is the $23.7 trillion market for US Treasuries, long thought to be the most liquid and stable in the world. Paradoxically, the Dodd-Frank-inspired rules have made the market more brittle by discouraging big banks from acting as intermediaries in the buying and selling of Treasury securities.
Given the potential for bigger financial pitfalls, Harvard’s Stein cautioned against taking too much comfort from the relative calm seen so far.
There’s also concern the financial damage from the central bank’s tightening campaign has been limited because investors in stocks and corporate bonds are clinging to the belief the Fed will quickly come to their rescue if markets suffer a deep dive.
While the Fed might “soften” its efforts to tighten credit if it were faced with a major financial disruption, such action would likely be temporary, said Stifel Financial Corp. chief economist Lindsey Piegza.
“The Fed is hyper-focused on fighting inflation,” she said.
Former Fed Vice Chairman Alan Blinder is among those who are optimistic the US will get through the current cycle without undue financial carnage.
Though policymakers always have to worry about what they don’t know – especially the unknown unknowns – “I’m reasonably optimistic” a breakdown can be avoided, the Princeton University professor said.
More stories like this are available on bloomberg.com.
