The Federal Reserve's Next Act Will Test Market Stability
The Federal Reserve's resolve to fight inflation could be tested even before a recession hits by dislocations in certain corners of the market that are not well understood. This is about more than just a bear market in stocks or an implosion in cryptocurrencies. Rather, this is about the “plumbing” that keeps markets running smoothly and facilitates the flow of money in and out of the financial system. Because it’s when cracks occurred here in the past that the Fed has been forced to adjust course -- often with little advance warning.
A look at the episodes in the past that prompted the Fed to alter its policy path or take emergency action reveals that disruptions in the smooth functioning of the money markets and the US government debt market have been the main triggers. Concern about these markets, which are essential to the stability of the financial system, will only grow as the Fed in just a few weeks begins to withdraw liquidity from the markets by reducing its $8.9 trillion balance sheet.
The problem is that what was once a rare occurrence is becoming more common. In 2019, the market for repurchase agreements seized following months of dwindling bank reserves as the Fed unwound its Treasury holdings. Then in March 2020, as the pandemic sent panicked businesses, consumers and investors in a dash for cash, liquidity in the then $17 trillion market for Treasuries suddenly vanished. The Fed responded with unlimited bond purchases that didn't come to a halt until this year. The Treasury market has since grown to $23 trillion.