New research points to the very real possibility that central banks will create a liquidity crisis by the end of the year

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Efforts to control inflation by central banks, in particular the Federal Reserve (Fed), could well trigger a liquidity crisis in the markets.

That’s the assessment of researchers at the University of Bath, who say excessive anti-inflationary policies could create a silver crunch this calendar year. Moreover, it shows that central banks can be a destabilizing factor as well as a stabilizing force in the economy with inflationary and deflationary policies.

An excellent example: 2008-09 and beyond

For example, the Bath study determined that during the 2008-09 financial crisis, central bank policies created more uncertainty in the markets, not less. This increase in uncertainty triggered market volatility, which in turn spooked investors. The fearful investment environment of that time made investors more conservative. As a result, money fled the markets to lower risk areas, making the markets even more volatile and illiquid.

The researchers noted that central banks’ rush to stimulate economic growth with artificially low interest rates and so-called quantitative easing (QE) in recent years has been excessive and is a major driver of the inflationary trend. current. Low interest rates have encouraged excessive borrowing by consumers and businesses, which has led to inflation in stocks, housing, cars and other markets.

Central banks are inflation arsonists

Moreover, it has been said by economists such as former Federal Reserve Chairman Paul Volcker and Joshua R. Hendrickson, assistant professor of economics at the University of Mississippi., that central banks are the cause of inflation.

“Who is responsible for inflation? In other words, if we compare inflation to a fire, is the central bank the arsonist or the firefighter? The answer is that central banks are the arsonists. Central banks are inflation makers, not inflation fighters,” Hendrickson wrote.

A caveat at this point, however, is that central bank policies are certainly not the only factor in the current inflationary cycle. The war in Ukraine, in particular, distorts world grain and energy markets. This and other geopolitical tensions, as well as supply chain disruptions in China, are also drivers of the inflation we are seeing.

A stork flies over a wheat field as a combine harvester from agricultural company TVK Seed harvests wheat near Myronivka, Ukraine, July 29, 2022. (Alexey Furman/Getty Images)

Deflationary policies can also cause instability

On the other hand, in their efforts to control inflation, central banks raise interest rates and tighten the money supply. Both of these policies aim to counteract inflationary influences, and may well do so. But, as even the Fed admits, they could do much worse.

The University of Bath study posits that, just as central banks have been overextending their quantitative easing policies in recent years, it is possible that the Fed’s interest rate hikes will be too aggressive and that its tight monetary policy remains in place for too long.

The rationale for both measures is that higher interest rates increase the cost of borrowing and therefore should eventually lower the demand for goods and services. The chain reaction should bring down inflation (goods prices). Monetary tightening, of course, means reducing the amount of money in the economy, which should also lower prices.

Flight to safety only worsens liquidity crisis

As noted, the uncertainty is driving investors to look for safer places to park their money.

The Bath study found that “in times of financial crisis and times of market uncertainty, investors move their funds to where they believe it is safest. This flight to safety can lead to a huge shortage of liquidity, forcing banks and financial firms to sell securities to meet increased demand for cash, which in turn drives down stock prices in the financial sector.

In practice, as the difference between the federal funds rate and the deposit rate increases – known as the deposit spread – it becomes more expensive for people to hold not only cash, but also bank deposits. As a result, households and businesses are shifting their money from bank deposits to other assets that are often less liquid but offer better yields, such as bonds. When deposits are withdrawn from banks, banks have less money to lend, and liquidity decreases.

This is a real fear of the Fed.

Liquidity keeps markets functioning

Liquidity fears are already felt in the markets for several reasons, including the war in Ukraine. Even the Fed recently expressed in its May 2022 semi-annual report its concerns about liquidity problems. No doubt investors are well aware of the Fed’s concerns.

Keep in mind, for example, that the US markets are the largest and most successful in the world due to their high liquidity and the power and ubiquity of the US dollar. Almost any asset can be exchanged for dollars without any disruption in the prices of the asset itself. U.S. financial markets cannot function without sufficient liquidity to allow such transactions to proceed smoothly and predictably. However, today it is a risk.

How financial analysts measure liquidity varies. In the stock market, measures of liquidity include average daily volume, the number of shares bought and sold, or what is called market depth, which measures both the quantities of shares or contracts that are lower or higher than the offer prices.

Other reasons why liquidity has decreased in the stock market are regulations that have reduced display orders. This reduces the market information available to traders and market makers, resulting in less active trading.

Investors are very worried

But academics aren’t the only ones worried about the potential downsides of an overactive central bank. Peter Boockvar, chief investment officer of Bleakley Advisory Group, spoke with concern about the next rate hike that will take place this month.

“After next week’s rate hike, we’re going to start playing a dangerous game with the state of the economy. The next rate hike will be only the second time in 40 years that the federal funds rate has exceeded the previous high in a rate hike cycle. … We are entering dangerous waters,” Boockvar told CNBC’s “Fast Money” on Sept. 13.

The concern is that if either policy is applied excessively, either or both will do more harm to the economy than good and add more uncertainty to the market. , Not less. It’s a reasonable assumption. At present, investors at all levels do not know to what extent and for how long these policies will remain in place.

This uncertainty, which adds to the negative sentiment, combined with higher interest rates and a weaker money supply, creates a shortage of liquidity, which can trigger all kinds of disruptions in the economy, especially in US markets. .

Indeed, liquidity has been slowly draining from various markets to the point that the Fed warned this month that it was threatening financial stability.

The question is: will the Fed make the situation better or make it worse?

The opinions expressed in this article are the opinions of the author and do not necessarily reflect the opinions of The Epoch Times.

James Gorrie

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James R. Gorrie is the author of “The China Crisis” (Wiley, 2013) and writes on his blog, TheBananaRepublican.com. He is based in Southern California.

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