Powell Says Soft Landing Will Be “Challenging,” Key Takeaways from Fed Financial Stability Report
Powell Says Soft Landing Will Be “Challenging,” Key Takeaways from Fed Financial Stability Report
Markets were down for the eighth consecutive week as they continued to process a plethora of risks. One of the primary risks that investors are focusing on is the Federal Reserve’s resolve in tackling inflation. Earlier this week Chairman Powell gave some more clarity. While he acknowledged it was the goal of the FOMC to achieve a “soft landing,” he said it would be “challenging” to achieve such an outcome. The official definition of a “soft landing” would be for the Fed to bring down inflation from its multi-decade highs to its target of 2% without causing a recession in the United States.
Specifically, the Chairman mentioned that the already arduous task of achieving a soft landing for the US economy is even more difficult because of developments like the Russia/Ukraine War and associated commodity disruptions. The committee has achieved some of its desired effects of tightening, and rate-sensitive areas of the economy like the mortgage market have started to cool. However, given other risks, if spending cools more quickly than anticipated and the strength of consumer balance sheets are sapped by inflationary pressures, then things could reverse quickly.
Economists at Deutsche Bank, Bank of America, and others on the Street, have cast major doubts about the Fed’s ability to navigate its biggest challenge in a generation without some collateral economic damage. Deutsche Bank feels the Fed will raise rates above 5% before finally getting a handle on inflation, which is significantly higher than the 3% expected by many Fed watchers.
They are anticipating a recession to materialize in the coming months. Generally, many feel that the Fed moved too late to tame inflation and the risk of a policy error is rising. While hotly debated at every print, there is evidence that several episodic drivers of inflation are peaking, or that they will imminently. Bearish prognostications are betting that inflation will cause a recession. However, others on Wall Street find such an outcome less likely, at least in the near term. JP Morgan researchers, for instance, think growth will take a while to slow down and a near-term recession is unlikely.
Many may not realize that the Fed has considerable supervisory authority for large financial institutions and a mandate to promote financial stability in addition to its monetary duties. It recently released a 2022 report on financial stability, and we wanted to provide you with a few takeaways.
The Fed mentioned that economic uncertainty has led to large fluctuations in the prices of financial assets. Even though rates have risen, the Fed still saw some asset prices as elevated compared to underlying cashflows. House prices continued to rise at a rate above rents, but the composition of mortgage demand and products is much healthier than before the Global Financial Crisis. Banks have healthy capital ratios above minimum requirements. However, leverage at insurance companies and hedge funds is high compared to the past.
One area of potential vulnerability flagged in the report was that stable coins and certain types of Money Market Mutual funds (MMFs) are vulnerable to runs in a forced liquidation environment. Interest coverage ratios at many large businesses are greater than the historical average. Household debt was increasing, but the credit quality of borrowers seems robust so far. One genuinely concerning weak point in the financial system is the central counterparties that clear derivatives. They cannot be resolved effectively through the bankruptcy process or the Fed’s extraordinary Orderly Liquidation Authority (OLA). They experienced larger margin calls due to the recent volatility in markets. The FOMC will meet on June 14th and 15th. The yield on the 10-yr closed Friday at 2.792%. Quantitative tightening begins in June as well.
