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Fed warns sharply higher interest rates could spark financial distress

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The US Federal Reserve warned of the potential for financial distress that damages the economy if interest rates rise to levels higher than expected, in a report that underscored the stakes of its drive to control stubborn inflation.

The central bank’s latest report on financial stability published on Friday highlighted a constellation of risks including a weaker global economy, “unacceptably high” inflation, and geopolitical turmoil. These currents have magnified volatility in some asset classes.

The report arrived two days after the Fed raised benchmark interest rates by 0.75 percentage points for the fourth time in a row, bringing them to a new target range of 3.75 per cent to 4 per cent. As recently as March, rates hovered near zero. The Bank of England also raised rates by 0.75 percentage points on Thursday, with the European Central Bank also opting for a jumbo rate rise last week.

The Fed is raising rates in an attempt to cool down an economy marked by persistently high inflation. Should they need to rise more than expected, that “would weaken the debt service capacity of households and businesses and lead to an increase in delinquencies, bankruptcies, and other forms of financial distress”, its financial stability report said.

The Fed added this could eventually lead to heightened volatility in markets, strained liquidity and further drops in asset prices, including in housing.

“Such effects could cause losses at a range of financial intermediaries, reducing their access to capital and raising their funding costs, with further adverse consequences for asset prices, credit availability, and the economy,” said the report, which is issued twice a year .

Lael Brainard, the Fed vice-chair, in a separate statement on Friday, highlighted the volatility that has engulfed some financial markets over the past six months, and underscored that the central bank would be “attentive” to financial stability risks.

“Today’s environment of rapid synchronous global monetary policy tightening, elevated inflation, and high uncertainty associated with the pandemic and the war [in Ukraine] raises the risk that a shock could lead to the amplification of vulnerabilities, for instance due to strained liquidity in core financial markets or hidden leverage,” she said.

A rapid string of interest rate rises, followed by the potential of a recession, have ignited fears of an unintended market meltdown, especially given strained liquidity conditions. The Fed said there were signs delinquencies on new home mortgages were creeping up and downgrades in the corporate sector had quickened.

However, the Fed noted leverage within the US banking system remained relatively low and large banks were well capitalized to absorb shocks “even during a substantial economic downturn”. Systemically important banks have started to reduce the risk on their balance sheets, the Fed added, and their vulnerability to credit losses appeared “to be moderate”.

Banks have struggled to offload risky loans they underwrote over the past year, before financial markets slid in value, holding tens of billions of dollars’ worth in connection to deals including the buyouts of Twitter, software maker Citrix and television rating group Nielsen. This has hampered their ability to lend to other big but low-rated businesses.

While banks and dealers have profited handsomely through their trading operations this year, bolstered by violent swings in financial markets, the recent chaos in the UK sovereign bond market has raised concerns for policymakers.

The sell-off in gilts offered a glimpse into how quickly turmoil in one corner of the market can spread. Volatility stretched to US credit markets as British pension funds sold parts of their portfolios to meet large margin calls.

The Fed noted that the volatility stemming from foreign risks, including those tied to China and the war in Ukraine, could “pose risks for institutions that are hedging dollar positions and to market functioning”, as well as present issues for emerging markets that have borrowed in dollars.

“Continued or more extreme market volatility could contribute to liquidity strains that play out in unexpected ways,” the Fed wrote. “Structural vulnerabilities” in short-term funding markets could further amplify the problem.