The Fed Has Absolutely Nothing to Worry About. Right?
(Bloomberg Gadfly) -- Here's something sobering that several central bankers expressed in the latest Federal Reserve meeting: Low benchmark borrowing costs may be starting to pose a more serious threat to long-term financial stability, according to Fed minutes released today.
U.S. central bankers have worried about frothy markets for some time, but some of them are feeling a greater urgency to do something. There are several reasons for this, but one stands out. President Donald Trump and his cabinet members have taken an aggressive stance toward loosening banking regulations. The danger here is age-old -- as banks engage in riskier activities, low rates allow them to take on more leverage until, suddenly, boom.
The Fed is in a position to stop, or at least slow this process, by tightening monetary policies. By lifting the near-term interest rate, the Fed could make it less economically attractive for firms to increase leverage, or borrow short-term money to invest in longer-term assets.
In that scenario, the Fed could potentially send the U.S. economy into a recession, or at least ignite a market correction. But some policy makers may feel it's worth it, since it would take steam out of high-flying markets.
Rock-bottom rates are making some central bankers a little queasy. Dallas Fed President Robert Kaplan noted on Tuesday that he found the persistently low yield on 10-year Treasuries "a little ominous" -- especially because they've been declining relative to shorter term rates.
"What I don’t want to see us do is raise rates so fast that we get an inverted yield curve because history has shown an inverted yield curve has tended to be a precursor to a recession," he said.
Indeed, U.S. yield curves have been flattening:
Yet the market is still expecting the Fed to hike rates in December, with the implied chances of a move rising over the past month to about 77 percent, according to derivatives traders.
It's very likely that Fed Chair Janet Yellen and her peers would feel less inclined to raise interest rates again in the near term if it weren't for the recent chipping away of post-crisis rules. After all, Yellen said back in June that those regulations have substantially fortified the banking system. She also said that she didn't expect to see another crisis in her lifetime that compares with the 2008 credit meltdown.
In August, Yellen distanced herself from Trump's anti-regulatory rhetoric, saying any rollback should be "modest" and noting that new regulations have made the financial system much safer.
Then last week, the Treasury Department unveiled a 220-page report laying out a series of recommendations aimed at undoing rules affecting the largest banks, hedge funds and exchanges.
The Fed undoubtedly took note. Central bankers have been well-aware that they're facing an unpredictable backdrop from regulators and politicians. And they have a wary eye on investors who've been all-but lulled to sleep in the face of any and every risk.
There's a difference between high asset valuations and a dangerous bubble. Prices can go down without causing the entire credit system to collapse. But if investors end up questioning the integrity of financial institutions they rely on, or basic instruments they've come to think of as safe and reliable, the trust that underpins the entire monetary structure frays. This is far more dangerous.
The looser the White House makes the rules, the more likely it is that central bankers will consider taking away bankers' punch bowl.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.
To contact the editor responsible for this story: Timothy L. O'Brien at tobrien46@bloomberg.net.