Federal Reserve researchers and officials quizzed experts from Wall Street and around the world last week about a pressing question: Could a market meltdown like the one that happened in Britain late last month occur here?
The answer they got back, according to four people at separate institutions who were in such conversations and who spoke on the condition of anonymity to describe private meetings, was that it probably could — though a crash does not appear to be imminent. As the Biden administration did its own research into the potential for a meltdown, other market participants relayed the same message: The risk of a financial crisis has grown as central banks have dramatically raised interest rates.
The Bank of England had to swoop in to buy bonds and soothe markets after the British government released a fiscal spending plan that would have stimulated an economy already struggling with punishing inflation, one that included little detail on how it would be paid for. Markets lurched, and pension funds using a common investment strategy found themselves scrambling to adjust, prompting the central bank’s intervention.
While the shock was U.K.-specific, the violent reaction has caused economists around the world to wonder if the situation was a canary in a coal mine as signs of financial stress surface around the globe.
Officials at the Fed, Treasury and in the White House are among those trying to figure out whether the United States could experience its own market-shuddering meltdown, one that could prove costly for households while complicating America’s battle against rapid inflation.
Administration officials remain confident that the U.S. financial system is unlikely to see such a shock and is strong enough to withstand one if it were to come. But both they and the Fed are keeping close tabs on what is happening at a moment when conditions feel abnormally fragile.
Markets have been choppy for months in the United States and globally as central banks — including the Fed — rapidly raise interest rates to bring inflation under control. That has caused abnormally large price moves in currencies and other assets because their values hinge partly on the level of interest rates and on international rate differences. Stocks have been swinging. It can be hard to quickly find a buyer for U.S. government bonds, although the market is not breaking down. And in corners of finance that involve more complicated investment structures, there’s a concern that volatility could trigger a dangerous chain reaction.
“In the market, there is a lot of worry, and everyone is saying it feels like something is about to break,” said Roberto Perli, an economist at Piper Sandler who used to work at the Fed and who was not part of the conversations last week, adding that it makes sense that officials are checking up on the situation.
President Joe Biden has repeatedly convened his top economic aides in recent weeks to discuss market flare-ups like the one that roiled Britain.
Fed officials and staff members have met with investors and economists both during normal outreach and on the sidelines of the World Bank and International Monetary Fund annual meetings last week in Washington.
Fed researchers asked about three big possibilities during the meetings. They wanted to know whether there could be a trade or an investment class in the United States similar to British pension funds that could pose a significant and underappreciated threat.
They also focused on whether problems overseas could spill back over to the U.S. financial system. For instance, Japan is one of the biggest buyers of U.S. debt. But Japan’s currency is rapidly falling in value as it holds its interest rates low, unlike other central banks. If that turmoil caused Japan to reverse course and stop buying or even sell U.S. Treasurys — something it has signaled little appetite for but that some on Wall Street see as a risk — it could have ramifications for U.S. debt markets.
The final threat they asked about focused on whether today’s lack of easy trading in the Treasury market could turn into a more serious problem that requires the Fed to swoop in to restore normal functioning.
None of those areas appears to be at immediate risk of snapping, analysts told officials. The pension system in the United States is different from that in Britain, and the government debt market may be choppy, but it is still functioning. Yet they also voiced reasons for concern: It is impossible to know what might break until something does. Markets are large and intertwined, and comprehensive data is hard to come by. Given how much central bank policy has shifted around the world in recent months, something could easily go wrong.
There is a good reason for officials to fret about that possibility: A market meltdown now would be especially problematic.
A financial disaster could force the Fed to deviate from its plan to control the fastest inflation in four decades, which includes raising rates rapidly and allowing its bond portfolio to shrink. Officials have in the past bought large sums of Treasury bonds in order to restore stability to flailing markets — essentially the opposite of their policy today.
Central bankers would likely try to draw a distinction between bond buying meant to keep the market functioning and monetary policy, but that could be hard to communicate.
The White House, too, has reasons to worry. Biden was scarred by his experience as vice president throughout the Great Recession, during which a financial meltdown brought on the worst downturn since the 1930s, throwing millions out of work and consuming the Obama administration’s policy agenda for years of a painstakingly slow recovery.
Biden has pressed his team to estimate the likelihood that the United States could experience another 2008-style shock on Wall Street. Treasury Secretary Janet Yellen and her deputies have been closely monitoring developments in the market for U.S. government debt and searching for any signs of U.K.-style stress.
While administration officials noted that trading has become more difficult in the market for Treasury bonds, they also pointed out that it was otherwise functioning well. Multiple officials said this week that they expected the Fed would step in to buy bonds — as the Bank of England did — in an emergency.
Other administration officials came away from their meetings in Washington last week with increased worries about financial crises sprouting in so-called emerging markets, like parts of Africa, Asia and South America, where food and energy prices have soared and where the Fed’s steady march of interest rate increases has forced governments to raise their own borrowing costs. Such crises could spread worldwide and rebound on wealthier countries like the United States.
Yet administration officials say the U.S. economy remains strong enough to endure any such shocks, buoyed by still-rapid job growth and relatively low levels of household debt.
“This is a challenging global economic moment where stability is hard to find,” said Michael Pyle, Biden’s deputy national security adviser for international economic affairs, “but the U.S. has momentum and resilience behind its economic recovery, and a trajectory that puts the U.S. in a strong position to weather these global challenges.”
And there is no guarantee that something will blow up. A senior Treasury official said this week that financial risks have risen with high inflation and rising interest rates but said a variety of data the department tracks continue to show strength in U.S. businesses, households and financial institutions.
For now, markets for short-term borrowing, which are crucial to the functioning of finance overall, look healthy and fairly normal, said Joseph Abate, a managing director at Barclays. And officials are working on safeguards to stem the fallout if a disaster should come. The Financial Stability Oversight Council, which Yellen chairs, discussed the issues at its most recent meeting earlier this month, hearing staff presentations on U.S. financial vulnerabilities.
The Treasury Borrowing Advisory Committee, an advisory group of market participants, has been asked in its latest questionnaire about a possible Treasury program to buy back government debt. Some investors have taken that as a signal that they are worried about a possible problem and may want to be able to improve market functioning, especially in light of their comments and outreach.
“We are worried about a loss of adequate liquidity in the market,” Yellen said last week while answering questions after a speech in Washington.
And the Fed already has outstanding tools that can help to stabilize markets. Those include swap lines that can funnel dollars to banks that need it overseas, and which have been getting used by Switzerland and the European Central Bank in recent weeks.
Abate at Barclays said that it seems like the Securities and Exchange Commission, Treasury and Fed are “on top of” the situation.
“It’s clear in the marketplace that liquidity is a concern,” Abate said. “The regulators are moving to address that.”
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