“Fear of fear itself”: the alarming prediction made by the brand-new Nobel laureate in Economics about the market

The American Economist Douglas Diamond rose to international fame last week, being awarded the Nobel Prize in Economics 2022. Diamond shared the top prize in the discipline with two other famous American economists, the former chairman of the Federal Reserve Ben Bernanke and Philip Dybvig“for his research on banks and financial crises”, and studying how financial markets should be regulated.

Diamond offered this Monday an interview with Business Insiderwhere he declared that “two trends run the risk of hitting the financial system of the United States”: on the one hand, a vertiginous rise in rates can produce public distrust in the system and outflow of funds; on the other hand, find the highly exposed companies to the increase in credit.

“If the Fed were to enact unexpected rate hikes, it could cause chaos in the market and cause the public to lose faith in the system”

Diamond knows a thing or two about the financial system and its vulnerabilities. He and his colleague Philip Dybvig, with whom he shared the Nobel Prize, along with former Federal Reserve Chairman Ben Bernanke, wrote a highly influential article in 1983 explaining the role of banks in the economy. The two detailed how banks act as valuable intermediaries by taking deposits from savers and offering long-term loans to businesses and other borrowers.

However, that balance can fade quickly if the appropriate protection mechanisms are not in place. If confidence in the financial system fades, a flood of savers can immediately withdraw their cash and bankrupt the very banks that underpin the entire system, Diamond and Dybvig wrote. It’s is what happened during the financial crisis of 2007. The collapse of subprime mortgages destroyed public confidence in banks and kicked off the Great Recession as American spending plummeted.

Banks are in “much better capital positions than they were” before the Great Recession, said Diamond, a finance professor at the University of Chicago Booth School of Business. However, the coronavirus crisis and the next wave of inflation have plunged the financial system into a sea ​​of ​​uncertainty.

“The ‘fear of fear itself’ can trigger a vicious circle, in the case of unexpected policy changes”

Amid skyrocketing inflation and the Federal Reserve’s historically intense fight against rising prices, it may It doesn’t take much for mistrust to grow in the financial sector. Financial crises are inherently unpredictable, and faster rate increases than usual could be enough to end the sense of security from the public, Diamond acknowledged.

“It takes at least somewhat unexpected events to cause a financial crisis, or the kind of race where there is enough loss of confidence and loss of net worth that people rush to leave before others arrive there,” the expert told Business Insider. “The ‘fear of fear itself’ or a kind of self-fulfilling prophecy”.

Forecasts for a 2023 recession are getting worse, inflation remains historically high and the labor market is weakening

So far, the Fed has avoided such a surprise. The US central bank has effectively anticipated its rate decisions in the weeks leading up to its policy meetings, leading investors and economists to at least have a fairly reliable forecast of how high interest rates will move. .

That security is not a given, and the recent events in the UK provide a prophetic example how an unexpected policy can surprise the public. After the prime minister’s tax proposals Liz Truss hit the pound and government bonds, the Bank of England was forced to step in with unlimited bond purchases to boost the market. The move undermined the British central bank’s efforts to cool inflation by pumping more cash into the struggling economy and, while some of the damage has since been mitigated, the episode has eroded confidence in the UK financial sectoras evidenced by a weaker pound and higher yields on government debt.

“The last thing the United States needs right now is another financial crisis, but two trends leave the country exposed to such a catastrophe,” Diamond warned.

With the pandemic, the war between Russia and Ukraine and a global slowdown that generates great uncertainties, the Fed is not safe from a similar episode. Unexpected rate moves could be enough for investors to move their money around and sow some discord in financial markets, Diamond said in the interview.

“Say you knew interest rates were going to go up 300 basis points next month. You would plan ahead to make sure you don’t have a portfolio that is going to run out,” he said. And he added that “the financial crises have to be reasonably unpredictable if people are sensible about how they allocate their funds.”

The Fed’s hike cycle is made even more powerful by the long period of rates close to zero that preceded it. The companies and borrowers they expected short-term rates “to remain basically constant and around zero for a long period of time,” Diamond said. In other words, it has been relatively cheap for people to acquire a credit card, a car, a mortgage or any other type of debt.

“The years of low interest rates are coming back to haunt the US”

“People weren’t buying insurance through long-term debt or through swaps of interest rates,” he told Business Insider. “With that circumstance, when you really increases interest rates quickly, you will be really exposed. That’s why we’re really exposed right now,” he said.

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. increases raise borrowing costs across the economy, affecting all types of loans, from mortgages to credit card debt. The mortgage rates, for example, have skyrocketed from 4.2% when the Fed started this cycle of rate hikes to 6.9% now.

Interest rate increases also make it much more expensive to service corporate debt, which in turn increases the risk of bankruptcy. If consumers and businesses start to feel a credit crunch, it could trigger a vicious circle similar to the one the world went through in 2007.

“Years of near-zero interest rates leave businesses ‘really exposed’ to rising borrowing costs”

Fed officials have also made it clear that their hike plans are far from complete. The projections published by the central bank indicated that the authorities will raise their reference rate by another three quarters of a percentage point in November and half a point in December. The inflation data worse than expected on Thursday led the market to brace for even more aggressive action .

Therefore, Diamond considered that as rates rise higher and intensify the debt burden of companies and borrowers, the chances that the financial system will be affected will increase.

“The long low period and quantitative easing allowed people to sleep easy because interest rates weren’t going to go up and they set up structures that if they did go up, they could get into trouble,” Diamond said. “Lo and behind, interest rates went up, and they could get into some trouble.”

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