Could the Fed trigger the next “financial crisis” as they begin to hike interest rates? Such is certainly a question worth asking as we look back at the Fed’s history of previous monetary actions. Such was a topic I discussed in “Investors Push Risk Bets.” To wit:
“With the entirety of the financial ecosystem more heavily levered than ever, the “instability of stability” is the most significant risk.
The ‘stability/instability paradox’ assumes all players are rational and implies avoidance of destruction. In other words, all players will act rationally, and no one will push ‘the big red button.’
The Fed is highly dependent on this assumption. After more than 12-years of the most unprecedented monetary policy program in U.S. history, they are attempting to navigate the risks built up in the system.“
The problem, as shown below, is that throughout history, when the Fed begins to hike interest rates someone inevitability pushes the “big red button.”
The behavioral biases of individuals remain the most serious risk facing the Fed. While they may hope that individuals will act rationally as they hike rates and tighten monetary policy, investors tend not to act that way.
Importantly, each previous crisis in history was primarily a function of extreme excesses in one area of the market or economy.
- In the early 70’s it was the “Nifty Fifty” stocks,
- Then Mexican and Argentine bonds a few years after that
- “Portfolio Insurance” was the “thing” in the mid -80’s
- Dot.com anything was a great investment in 1999
- Real estate has been a boom/bust cycle roughly every other decade, but 2007 was a doozy
What about currently?