Current Fed policy is combination of three strategies: one, raise interest rates to choke inflation; two, continue to cut the Fed's balance sheet through QT to return to normal; and three, don't blow-up the financial system in the process of following one and two. We now know that it is not easy to meet all three goals.
Raising interest rates from the zero bound will have ramification greater than just slowing economic growth. Financial markets have been addicted to low rates and the transition is more difficult than expected. These are the not so hidden risks of repricing assets. Even with book value accounting, the losses may be delayed but will not be hidden.
QT is a long-term goal, yet we now see that if there is a financial crisis, the Fed balance sheet can balloon quickly and reverse months of QT sales. We are also aware of the impact of QT on bank reserves and overall market stability. The recent bank funding can be considered similar to the BOE gilt purchases last fall It will be hard to lower the balance sheet if there are continual crises from raising rates.
Financial stability is paramount in attempting to minimize the chance of pushing the economy into a recession, yet raising interest rates increases financial instability. Stability is based on asset prices not falling. Full stop, asset values are being repriced and there will be losers. The trade-off is becoming clear, control inflation and increase financial instability or lower rates to support the banking system but allow for more inflation.
The bond market may not be right, but it is pricing in lower rates as a central bank attempt to minimize the risk for a financial meltdown. The Fed has erred in the past toward adding liquidity to solve a stability crisis. It is expected that this will happen again.
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