The Federal Reserve’s Concerns About Inflation and the Risks to Financial Stability

Investing.com — After navigating the 2008 financial crisis, Neil Kashkari worries about systemic risks. But now, as a US monetary policy maker, he is more worried about inflation.

“I think if I had to make a mistake, I would make the mistake of being a little bit aggressive about cutting inflation,” a president in Minneapolis told Reuters last week.

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Kashkari and some other Fed officials were caught off guard by persistent inflation in the face of the fastest rate of hike since the 1980s, and have ratcheted up tensions again in recent days, with hawkish expectations on interest rates.

In doing so, they may inadvertently set the stage for the next market crisis, necessitating the intervention of the Federal Reserve to undermine its hawkish monetary policy.

So the Fed’s attempt to steer the economy into a so-called “soft landing” for the economy while maintaining financial stability raises the odds that the downturn will be rapid or a longer and more turbulent path.

As a result of the Fed’s policies, tensions have erupted in different parts of the global financial system, from the bursting of the crypto bubble a year ago to the turmoil in the US regional banking sector in March.

While it is not clear where the next storm will hit markets, potential sources of weakness abound, from commercial real estate to money market funds.

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Many risks

Markets have stabilized since the worst of the banking turmoil subsided. As the economy remains resilient, investors are still betting that the Fed may cut inflation without causing too much economic pain or instability.

Earlier this month, Jerome Powell, Chairman of the Federal Reserve, said that the Fed’s monetary policy and financial stabilization tools “work well together,” allowing it to support banks and seek price stability.

But many market analysts believe that not only is the regional banking sector still under pressure, but there are still multiple other risks to financial stability, as tightening monetary policy may explode or exacerbate the impact of other shocks, such as the fallout from debt ceiling negotiations.

In the aftermath of the March banking crisis, the Fed was forced to step in with tens of billions of dollars in emergency support to the banking system.

Systemic trauma can come from both known and unexpected ways. In its latest Financial Stability Report earlier this month, the Fed listed several areas of concern, including life insurance and some types of bonds and loan funds.

The interest.. to where?

The market has long priced in interest rate cuts from major central banks at the end of 2023, but core inflation, labor markets and a resilient global economy are prompting some economists to reassess.

The stronger-than-expected US jobs numbers and GDP data highlighted a major risk to the Federal Reserve, which is likely to stray from stopping interest rate hikes.

The US CPI has fallen significantly since its peak above 9% in June 2022, falling to just 4.9% in April, but still well above the Fed’s target of 2%. The core CPI, which excludes volatile food and energy prices, rose 5.5% annually in April.

New data on Friday showed that the personal consumption expenditures price index, the Fed’s preferred gauge, rose 4.7% year-on-year in April, indicating more bets on a longer-term rate hike.

Meanwhile, Fed officials, including St. Louis Fed President James Bullard and Minneapolis Fed President Neel Kashkari, have indicated in recent weeks that high core inflation may keep monetary policy tightening for longer.