A GRADUAL TIGHTENING
June 28, 2004
For some weeks, Federal Reserve officials have signaled their intention to raise interest rates gradually. They believe that the economy is now on a sustainable upward course and that inflation now presents a greater risk than the danger of an economic relapse. Financial markets have been forewarned that they must adjust their portfolios and avoid the squeeze that comes when institutions have borrowed short and lent long, says Bruce Bartlett.
If the Fed is able to keep to a gradual pace of tightening, financial markets should be able to adjust without trouble. But there is always the danger that mistakes will be made or that unexpected circumstances may arise that will trap the unwary and create a crisis situation.
The possible risks, says Bartlett, include:
- The tiniest mistake by Fannie Mae and Freddie Mac (combined mortgage market debt of about $3 trillion) could massively disrupt financial markets.
- A slowdown in foreign Treasury purchases (foreigners now own more than 50 percent of liquid Treasury securities), perhaps due to fears of a fall in the dollar, would also be disruptive.
- A slowdown in the Chinese economy could force the Chinese to stop buying U.S. Treasury Bills and start selling them.
Any of these scenarios would cause a sell-off in the stock and bond markets as great or greater than the stock market crash of 1987, explains Bartlett. At that point, policymakers will be forced to adopt a significant deficit reduction program. They will have no choice because it will be the only policy action in their power to take and they will be strongly pressured to do so by the overwhelming force of public opinion.
Source: Bruce Bartlett, "A Gradual Tightening," National Center for Policy Analysis, June 28, 2004.
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