- Insider is told that two trends are at risk of threatening the US financial sector. Douglas Diamond, an economist and Nobel-winner, said that these two trends were alarming.
- He said that if the Fed were to announce unexpected rate increases, it could cause market chaos and lead to public distrust in the system.
- He added that companies are “really vulnerable” to rising borrowing costs because of years of almost-zero interest rates.
The forecasts for a recession in 2023 are getting worse, inflation is still historically high and the labor market softening.
A new financial crisis is not what the US needs at the moment. But two trends make it more vulnerable to one, Douglas Diamond, one the three winning economists. Nobel Memorial Prize in Economic SciencesOn Monday, Insider.
Diamond is an expert on the financial system and its weaknesses. He and his colleague Philip Dybvig — with whom he shared the Nobel prize, along with former Federal Reserve Chair Ben Bernanke — wrote a hugely influential PaperThe 1983 article explained the importance of banks in the economy. These two explained how banks are valuable intermediaries, taking deposits from savers and providing long-term loans to businesses.
If the right backstops don’t exist, that balance can quickly unravel. Diamond and Dybvig said that if trust in the financial system erodes, an avalanche of savers could pull their cash and bankrupt the banks that support the whole system.
This was exactly what happened during 2007’s financial crisis. The subprime mortgage meltdown caused public distrust in banks, and kicked off a Great Recession when Americans’ spending plummeted.
Banks are in “much better capital positions than they were” before the Great Recession, Diamond, a professor of finance at the University of Chicago’s Booth School of Business, said. However, the coronavirus and subsequent inflation spells have left the financial system in a state of uncertainty.
“Fear of Fear” can be a catalyst for vici.Unexpected policy changes can cause a void in the cycle
It might not take long for the distrust in the financial sector to grow amid soaring inflation and the Fed’s historic intense fight against rising costs. Diamond stated that financial crises are unpredictable and that faster rate increases could cause public anxiety.
Insider told him that it takes at least some unexpected events to create a financial crisis. “The ‘fear that fear itself’ or selffulfilling prophecy style of run.”
The Fed has so far avoided this surprise. Economists and investors have been able, at most, to get a reasonably accurate forecast of the future rate movements by the central bank in the weeks leading up to their policy meeting.
This is not security, but recent events in the UK are a warning sign that unexpected policies can cause shock to the public. The Bank of England was dissolved after Prime Minister Liz Truss’s tax proposals had slammed both the pound sterling and government bonds. Forced to intervene with unlimited bond purchasesThe move was intended to boost the market. The bank’s efforts at cooling inflation by injecting more money into the struggling economy were thwarted by this move. However, some of the damage has been repaired.
The Fed can’t afford another similar episode with the Russia-Ukraine conflict, the pandemic and the global slowdown that has created huge uncertainties. Diamond suggested that unexpected rate movements could cause investors to shift their money and create discord within financial markets.
Let’s suppose you knew that the interest rates would rise by 300 basis points next week. You would plan ahead to avoid having a portfolio that is going to be destroyed,” he stated. If people are sensible about how they allocate funds, financial crises can be quite unpredictable.
The US is coming back from years of low interest rates.
The Fed’s rapid-fire rate hike is magnified by the extended period of near zero rates that preceded it. Diamond stated that businesses and borrowers had expected short-term rates to “stay basically constant and around zero” for a long period. It’s been very affordable for people to get a credit card or car loan, as well as any type of debt.
Insider was told that people were not buying insurance via long-term debt or interest-rate swaps. “In that situation, if you raise interest rates quickly, you will be really exposed. We are now really exposed.
The Fed’s rate hikes may seem small — fractions of a percentage point — on their own, but they can add up to a significant financial burden. The Fed’s rate hikes increase borrowing costs in the economy. They affect all types loans, including mortgages and credit card debt.For example, mortgage rates have risen from 4.2% to 6.9% since the Fed started this cycle of rate increases.
In addition to making companies’ debt more difficult to service, interest rate increases can also increase the risk of them going bankrupt. It could lead to a vicious cycle that is similar to the one experienced by the world in 2007.
Federal Reserve officials also stated that they are still working on their hiking plans. The central bank released projections that suggested policymakers will raise the benchmark rate. An additional three-quarters point is requiredIn November, the rate was 0.5 percent and December it was 0.6 percent. Thursday’s lower-than-expected inflation data caused the market to react. For more aggressive action, brace.
The chances of financial-system problems will increase as interest rates rise and debt burdens are increased on borrowers and companies.
Diamond said, “The low-forlong period and quantitative ease let people rest easy that interest rate weren’t going up, and set up structures to, if it went up, get into trouble.” “Lo, behind, interest rate went up, and they might end up in some trouble,” Diamond said.
