The asset bubble that’s quietly popping

Powell and other Fed policymakers are meeting this week to raise borrowing costs again in a fight against the highest inflation in four decades if they are close to winning. But the lack of major pressure on the financial system so far has bolstered President Joe Biden’s hopes that any recession could be weakened — or averted altogether.

If the Fed can reduce inflation without causing an economic collapse – to achieve the so-called soft landing that has eluded the central bank in the past – it will defy the warnings of Wall Street CEOs and most economists.

“The good news about the bursting of these bubbles is that they didn’t lead to a general market crash,” said Kevin Gordon, senior manager of investment research at Charles Schwab, who pointed to the decline in speculative investments such as crypto and micro. stocks. But “definitely there needs to be more air.”

To be sure, economic risks still weigh heavily on the downside, as Wall Street executives like JPMorgan CEO Jamie Dimon warned last week. “Inflation,” Dimon said, “destroys everything.”

The biggest risk in Powell’s fight against inflation is that interest rate hikes take time to feed into the economy. That means the Fed’s aggressive moves now could pack a much bigger punch next year as consumers reduce their savings and take on more debt. And that’s especially true if unemployment rises, as almost everyone expects.

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While companies have been able to refinance their loans at very low rates in the coronavirus pandemic, there may be a reckoning for them, as some of the firms eventually have to take on the rising cost of debt.

And it’s not just a US problem: Inflation has soared in countries around the world, fueled by supply chains and Russia’s war in Ukraine, while higher US rates have hit smaller economies hard, raising the possibility of a global recession.

Yet a Biden administration official said the lack of market turmoil in the US is a good sign and that banks have healthy financial buffers to deal with unexpected losses. That reduces the chances of financial shocks sending the country into recession.

That’s a stark contrast to the credit crisis of 2008 when homeowners were saddled with risky mortgages, and financial institutions around the world were exposed to junk assets with those loans, leading to the Great Depression.

“There is a path to slower growth without much pain at home, and that’s because labor markets and balance sheets still look strong,” said the official, who asked not to be identified to speak freely about the administration’s views. “We don’t see the kind of things that would cause some kind of decline.”

“But we must always prevent that,” the official added. “You can never be completely confident at times when you think the risk of shock is high.”

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The Fed continued the movement of financial asset prices last year, from stocks and real estate to crypto, by reducing interest rates to zero and buying trillions of dollars in bonds. Now, as the central bank raises rates at the fastest rate in decades to curb inflation, Americans are staring at a recession.

Amid the recession and the gloom of inflation and rising interest rates, stocks are down nearly 18 percent this year. Home prices fell 2.6 percent in the third quarter in the face of a punishing jump in mortgage rates. Even bonds have been turned upside down, with one Bloomberg index down more than 11 percent by 2022.

Part of the reason it hasn’t led to more dramatic results — layoffs in the tech industry have been one notable exception — is because those stocks were starting from the top, said Alp Simsek, a professor at the Yale School of Management.

“We’re getting back to normal levels,” he said.

He pointed out that asset prices are influenced by more than the speculative frenzy tied to inflation in the economy. Because the Fed lowered interest rates and bought more US government debt and mortgage-backed securities during the pandemic, the price of many things rose naturally.

“When we were in a recession, the economy needed high asset prices to recover quickly, but once it recovers, you want to remove that energy,” he said. “In theory, this works. In fact, when asset prices rise and fall rapidly, there is a risk of asset collapse.

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Schwab’s Gordon said U.S. consumers were also protected by the strength of the labor market. When people are employed, they are less likely to be forced to sell their homes or other assets to survive. Still, he noted that consumer savings have begun to wane.

“At the same time, credit card debt has increased,” he added. “All of that, to me, suggests that there’s a lot of pressure under the surface.”

Meanwhile, the tighter the labor market remains, the more the central bank may have to raise interest rates, especially given recent data showing that wage growth is picking up amid signs that inflation is cooling.

“There is a risk of complacency given the credit performance during this pandemic,” Acting Financial Director Michael Hsu, who oversees the country’s banks, told reporters on Thursday. “We must remain vigilant.”

There is always the danger that firms in unregulated corners of the financial system will make risky investment decisions that blow up and eat away at key players, destabilizing the economy. But there are few hints so far that such an event is on the way, even as those precise movements play out in the world of crypto assets.

Kathryn Judge, a professor at Columbia Law School said: “Because of the speed and the way things have changed, things can go much, much worse than they are. “But I’m not going to rest easy until we have more time for the big changes that we’ve seen in the interest rate environment to be successful.”

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