Saturday, January 30, 2010

Fed Warns Complacency Will Trigger New Turmoil


The Federal Reserve's No. 2 official issued a stern warning to investors, banks and other financial institutions Friday: Don't be complacent, interest rates are going up at some point and they will trigger new market turmoil if you're not prepared.

"We are in uncharted waters for monetary policy and the financial markets," Donald Kohn, vice chairman of the Federal Reserve, said in a speech to bankers at the Federal Deposit Insurance Corp. Rattling off a long list of uncertainties—including a rising budget deficit, foreign demand for U.S. debt and the strength of the recovery—Mr. Kohn said bankers need to start preparing now for the risk that interest rates could move swiftly in unexpected directions, most likely up.

"Many banks, thrifts and credit unions may be exposed to an eventual increase in short-term interest rates," he warned.

He said long-term interest rates could also be pushed up, in part because large government borrowing to fund budget deficits could crowd out private borrowing. That would make it more expensive for companies to borrow from the market.

Foreign demand for U.S. debt could also narrow if countries with large trade surpluses with the U.S. shrink those surpluses and thus accumulate fewer dollars. In that case, the U.S. government would have to pay more to borrow from markets.

To counter the financial crisis, the Fed slashed short-term rates to near zero in December 2008 and said this week it expects them to stay at a record low for at least several more months. But Mr. Kohn warned there is uncertainty at the Fed about how to proceed. "Short-term rates will rise at some point, but when, how quickly, and by how much will depend on the outlook for economic activity and inflation," he said.

Several factors are behind the Fed's warning. Officials are on high-alert for new risks building in the financial system after the shocks of 2007 and 2008. Fed officials also don't want investors to believe that the way forward for interest rates is necessarily predictable and calm. One critique of the Fed's monetary policy between 2003 and 2005 was that it set out a path of interest-rate increases that was too predictable and helped lull investors into a sense of complacency about risk.

Write to Luca Di Leo at

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