Loose Monetary Policy Can Trigger ‘Financial Turmoil’ in the Future, Fed Admits in New Paper

Federal Reserve Board Chairman Jerome Powell looks on during a news conference following the announcement that the Federal Reserve raised interest rates by half a percentage point, at the Federal Reserve Building in Washington on Dec. 14, 2022. (Evelyn Hockstein/Reuters)

The Federal Reserve adopting a loose monetary policy—slashing interest rates and buying Treasurys—for an extended period can lead to “financial turmoil” several years later, the central bank stated in a new paper.

Economists at the Fed Bank of San Francisco published a new study, titled “Loose Monetary Policy and Financial Stability,” (pdf) trying to determine whether accommodative conditions can lead to financial turmoil in the future. The researchers assessed long-term data to figure out if expanding money and credit can birth rampant speculation, raise household debt, and initiate an investment boom and “capital overhang.”

This was the first comprehensive study to extend the evidence that “monetary policy has implications” for the stability of the U.S. financial system, authors noted. The study considered the dangers of ”lower for longer monetary policy” that can lead to the consequence of financial crises.

“Given this concern, we explicitly consider the consequences of persistently loose monetary policy as opposed to single periods of policy undershooting relative to the natural rate of interest,” the paper stated.

“Are periods of persistently loose monetary policy more crisis-prone? This section argues that the answer to this question is in the affirmative. We see significant estimates in the medium term, that is around horizons of 5 to 10 years. Financial crises are predicted by loose monetary policy several years ahead.”

The study authors averred that they did not discover evidence to suggest there is a connection between loose monetary policy and financial vulnerabilities in the short term. The research found that there is actually a negative relation between a loose stance and financial fragility “at horizons below 4 years.”

Traders work at the New York Stock Exchange on July 27, 2022. (Timothy A. Clary/AFP via Getty Images)

However, historical data confirm that “running such a high-pressure economy may not be sustainable in general.” The Fed paper asserted that there is a “heightened risk of disasters” in the broader economy while realizing short-term gains, which can lead to more significant economic, political, and social costs.

“Policymakers should take the dangers imposed by keeping policy rates low for long seriously, and thus weigh the potential short-run gains of loose monetary policy against potentially adverse medium-term consequences,” the paper noted.

From Easing to Tightening

In the wake of the pandemic-induced economic collapse, the Fed intervened by cutting the benchmark federal funds rate to nearly zero, acquired trillions in Treasury and corporate bonds, and employed emergency loans. As a result, from February 2020 to April 2022, the Fed increased the money supply by 45 percent. The central bank’s balance sheet soared 115 percent in this period to just under $9 trillion.

It has been one year since the Fed started tightening monetary policy, pulling the trigger on a quarter-point rate hike. Since then, the institution has raised the policy rate by 425 basis points. Meanwhile, the money supply has tumbled roughly 4 percent from its peak, and the balance sheet has contracted close to 7 percent.

The central bank’s latest quantitative tightening (QT) is the sharpest on record, the San Francisco Fed said in a separate study.

The Fed’s efforts could lead to further declines in stock prices amid “more tightening in the bond market.” This was due to how easy monetary policy was when price inflation started rising at a rapid pace, which produced a “real rate gap.”

“While the rapid tightening of financial conditions is expected to slow the economy relatively quickly, historical experiences raise the possibility of even more tightening in financial conditions given the large real rate gap that needs to be closed,” the regional central bank stated.

With various metrics suggesting that the disinflation trend has slowed, many officials at the Fed have been entertaining proposals of raising interest rates firmly above the median 5.1 percent that was projected in the December Survey of Economic Projections.

In front of the Senate Banking Committee on Tuesday, Fed Chair Jerome Powell cautioned lawmakers that rates could head higher than the central bank initially expected, adding that its inflation fight is far from being finished.

“The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated,” he said in his opening remarks. “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”

According to the CME FedWatch Tool, investors are split on if the Federal Open Market Committee (FOMC) will pull the trigger on a quarter- or half-point rate hike. This has been a significant shift in expectations after the financial market had mostly penciled in a 25-basis-point increase at this month’s FOMC policy meeting.