A trio of U.S. economists, including the University of Chicago’s Douglas Diamond, has won a Nobel Prize for explaining the causes of bank runs and other financial crises. Their research sheds light on the economic effects of fear.
How fitting for the moment through which we’re living.
Global financial markets are facing their most treacherous period since the Great Recession of 2007-08. Another recession appears to be brewing, as central banks and policymakers grapple with persistent inflation.
The Fed has been jacking up interest rates aggressively. At each of its last three policymaking meetings, the U.S. central bank has raised its benchmark rate by three-quarters of a percentage point, an unusually steep increase. Another big boost is likely in November.
The overly complacent Fed was late to recognize the persistent inflation that every American by now has experienced firsthand: Prices are high at the gas station, grocery store, on Amazon, even at the local tavern. You know it’s bad when Social Security is forced to give its recipients an 8.7% cost-of-living raise, the biggest in 40 years.
To tame inflation and slow the hot labor market, the Fed needs to keep interest rates high for an extended period. But it will need to walk a tightrope to avoid putting an already fragile economy into a 2008-style tailspin.
Making this high-wire act more difficult is a factor that is starting to get the attention it deserves. For years after the 2008 financial crisis, and again during the COVID-19 pandemic, the Fed and other central banks bought bonds from the private sector. Those purchases of Treasurys and mortgage-backed securities, known as quantitative easing, pumped loads of cash into the financial system.
The result was easy money. As intended, the cash infusions stimulated economic activity, prompting investment and lending that would not have otherwise occurred. Complaints were few while the U.S. economy expanded, interest rates were kept low and credit limits went higher. The stock market soared relative to the value of goods and services. Inflation was under control, as had been the case for decades.
The sharp spike in prices beginning in early 2021 changed the game, and now the Fed has reversed course by letting some of the securities it holds expire without replacing them. As it shifts to quantitative tightening (as distinct from quantitative easing), the financial system becomes more vulnerable to shocks.
The Fed always recognized that it couldn’t hold these bonds forever. In 2007, before the crisis, the central bank held less than $1 trillion of long-term securities on its balance sheet. After more than a decade of QE stimulus, the figure stood at almost $9 trillion.
Today, given inflation, the Fed has little choice but to reduce its balance sheet while also raising rates — a double-whammy that marks an end to the easy money that greased the economy for all those years. Banks are starting to respond by increasing reserves and reducing credit lines. Their tight-fistedness could pull the rug out from bank clients who’ve been assuming they could borrow anytime they want.
Not anymore.
In the run-up to the Great Recession, the risks were difficult to track and often disguised. When a big, unexpected change occurred — in that instance, a sharp decline in home prices — all those slowly accumulating risks came to the forefront. Markets seized up, defaults mounted and an interconnected financial system had a meltdown.
The decline so far this year has been more orderly. We’ve seen no bank failures, no collapse in financial markets, no government bailouts — just huge frustration with rising prices and the Fed.
We did, however, see an ominous warning sign when a new British government announced unfunded tax cuts, and investors responded by dumping its sovereign debt. British policymakers retreated, and the market mostly righted itself, but only after a big scare that on Friday took down the British chancellor of the Exchequer, Kwasi Kwarteng, after just 38 days in office. On Friday, the volatility in the British pound was breathtaking.
On this side of the Atlantic, inflation has remained unacceptably high, as evidenced by the latest Consumer Price Index report on Thursday showing a stubbornly persistent 8.2% annual rate through September.
On Wednesday, the Fed published minutes of its most recent policy meeting that indicate a willingness to keep raising rates until inflation finally surrenders, even if it means layoffs and a recession. Inflation, it rightly feels, is that pernicious.
What to do? Well, you probably don’t need Nobel Prize-winning research on fear and the markets to tell you that by the time a financial panic really gets going, it’s too late to panic.
We endorse preparing your investment portfolio for the prospect of volatile times and keeping your finger off the panic button.
