Powell says rate hikes aren’t a stability risk. Others are less convinced.

The Federal Reserve is raising interest rates at its fastest pace in decades in an effort to stomp out inflation, but Chair Jerome Powell says the banking and financial sectors are well equipped to handle the impact.

After the Fed’s Federal Open Market Committee raised its benchmark interest rate by three-quarters of a percentage point on Wednesday, Powell said well-capitalized banks, responsive markets and strong household balance sheets paint a “pretty decent picture” of financial stability.

Others are less confident. 

“The risk to the market of economic stagflation is much more than the Fed or [Treasury Secretary] Janet Yellen want to acknowledge; the risk of an institutional failure is greater than what the chairman admitted in the press conference this week,” said Komal Sri-Kumar, a senior fellow at the Milken Institute and an independent macroeconomic consultant. “The Fed and Treasury are trying to be sanguine in public, but I hope that is not reflective of what they are doing on the inside to prepare for these events. ”

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Fed Chair Jerome Powell brushed off concerns that aggressive rate hikes could cause a big disturbance in the financial system. “There are plenty of macroeconomic issues that don't rise to the level of financial stability concerns,” Powell said after the FOMC raised its benchmark rate Wednesday.

Sri-Kumar is one of several economists and policy experts who believe the Fed’s rapid-fire rate increases could be a greater threat than Powell has acknowledged.

The FOMC has raised the target range for the federal funds rate by 0.75 of a percentage point in two consecutive meetings and by 2.25 percentage points overall in four months. The pace of tightening outpaces anything seen by the Fed in roughly 40 years. 

Financial institutions have had little time to adjust to the expedited tightening cycle. When the Fed began raising interest rates in March, most FOMC members expected to reach the current policy rate sometime next year, according to the committee’s Summary of Economic Projects. Since then, the Fed has adopted a more aggressive stance, vowing to move “expeditiously” to make its monetary policy less accommodating — and, if necessary, restrictive — to rein in soaring inflation. 

Changing interest rates faster than capital markets can adjust heightens the risk of defaults on loans and other financial instruments.

If such exposures are concentrated within large institutions the ripple effects could have a systemic impact. This was the case for the hedge fund Long-Term Capital Management in 1998, which required a Fed-brokered $3.6 billion recapitalization. 

The Federal Reserve has aggressively ratcheted up interest rates to tame inflation. But that swift turnaround after more than a decade of accommodative monetary policy could create new risks to the financial system.

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The Marriner S. Eccles Federal Reserve building in Washington on Feb. 19, 2021.

Powell brushed off these concerns during a post-FOMC meeting press conference Wednesday. He said asset prices have already come down in anticipation of rising interest rates, thus reducing the risk of rapid sell-offs. He also noted that household indebtedness is near an all-time low. There are risks, he said, but not at the systemwide level.

“There are plenty of macroeconomic issues that don't rise to the level of financial stability concerns,” Powell said. “Financial stability, you know, we think of that as things that might undermine the working in the financial system. So big, serious things.”

Yet, Powell’s rationale left some unsatisfied. Jeremy Kress, a business law professor at the University of Michigan and a former Fed attorney, said the question of how rapidly rising interest rates will be absorbed by financial institutions of all stripes is too complex to merely consider debt levels and asset prices.

"It's answering a financial stability question through a monetary policy lens,” Kress said. “The truthful answer would have been something a little more humble in terms of acknowledging that this is something the Fed needs to look at because it has not studied it formally."

Derek Tang, co-founder and managing partner of the think tank Monetary Policy Analytics, also found Powell’s stance on systemic risk lacking in nuance.

“[Powell] didn't give enough consideration to the potential amplifying effects of rapid rate hikes and how instability might show up only with a lag,” Tang said. “His argument about strong balance sheets being a strong buffer might actually mean some problems are hidden until things get even worse.”

Powell highlighted the ability of banks to mitigate volatility with their robust capital holdings, a nod to the results of this year’s stress test, in which all 33 banks examined passed with relative ease. But both Tang and Kress questioned whether this year’s stress-test scenario was comparable enough to draw meaningful conclusions.

“Those stress tests, designed in February, had much lower interest rates,” Tang said. “So that stress test doesn't reflect the big gyrations in yields since then.”

The Fed’s stress tests, which routinely examine how banks would be affected by changing interest rates, are not meant to mimic real or projected market conditions, but rather to evaluate how banks would perform when faced with severe, imagined scenarios. 

Beyond the stress tests, the impact of high inflation and rising interest rates has been a focal point for the Fed’s staff. It featured prominently in their more recent financial stability report in May and was listed as the No. 2 concern for market participants behind only Russia's invasion of Ukraine.

The topic of financial stability is a difficult one for the Fed chair to be candid about, Sri-Kumar said. Saying there is no possibility of systemic failure could embolden the market to take unnecessary risks, he said, while saying a failure is imminent could have a chilling effect.

“Internally, they are aware of it and they’re looking at that risk,” Sri-Kumar said. “Regulators need to be concerned about financial stability right now, but they’re not going to acknowledge it in public.”

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