Latest Fed Financial Stability Report Underplays Supply Chain Risk

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The Financial Times, Bloomberg, and the Wall Street Journal all gave enough different spins on the latest Fed Financial Stability report, which the central bank issues twice a year, that it seemed useful to give it a look. We’ve embedded it at the end of the post for your convenience.

The entire document is worth a look, since it has sections that may appeal to various interests, such as a post-mortem of the March 2020 Treasury market upheaval, a discussion of the risk of non-cash collateral at central counterparties, and meme stocks. But the part the press focused on was “Near-Term Risks to the Financial System,” which starts on page 59.

Regular readers would hopefully have internalized the Fed’s framework:

  1. Elevated valuation pressures are signaled by asset prices that are high relative to economic fundamentals or historical norms and are often driven by an increased willingness of investors to take on risk. As such, elevated valuation pressures imply a greater possibility of outsized drops in asset prices.
  2. Excessive borrowing by businesses and households leaves them vulnerable to distress if their incomes decline or the assets they own fall in value..
  3. Excessive leverage within the financial sector increases the risk that financial institutions will not have the ability to absorb even modest losses…
  4. Funding risks expose the financial system to the possibility that investors will “run” by withdrawing their funds…

I suspect experts like Steve Keen and Richard Vague would be more than a tad frustrated by this. Normally, in academic work and even financial reports, the ordering of items signals which is to be taken as most important. It’s distressing to see the central bank depict itself as concerned with asset price levels, and even worse, broadly stated.

Investors are supposed to be grown-ups and know that they are taking risk, as in the possibility of loss. Financial economics posits the existence of a risk-return tradeoff, that investors take more risk in the hope of getting better results.

So what a central bank ought to be concerned about is leverage of assets, and not asset prices per se. Recall that we had an enormous dot-com bubble, but in public stocks, and the regulators have strict limits on margin loans. When it imploded, there was no damage to the financial system (amusingly, there was to players that had managed to leverage themselves to the mania by taking Internet stocks in lieu of cash….like McKinsey, which had to write off $200 million. It also had to shrink its headcount by nearly 50% in two years in North America due to having greatly increased staffing to service dot-com panicked clients and serve clients who had eyeballs rather than cash).

But instead, the Fed sees itself as the guardian of asset prices generally, irrespective of the degree of blowback to financial institutions, because confidence fairy. The continuation of the Greenspan-Bernanke-Yellen put is what created these greatly attenuated valuations, but you never hear a hit of agency in how the Fed characterizes its “Gee, asset prices are pretty high” observation.

Most experts who have taken a hard look at crises have found that high levels of private sector borrowings, particularly by households, is what sets the stage for a financial crisis.

Another financial crisis risk factor, oddly absent from the Fed’s list, is high levels of international capital flows. An 800 year study of financial crises by Ken Rogoff and Carmen Reinhart found that high levels of international capital movements were strongly correlated with rising and increasingly severe financial crises. When their study came out, it received all sorts of approving noises. But no one was willing to act on its obvious implications and start imposing capital controls, or at least increase frictions through transactions taxes. Can’t wind the clock back on the supposed progress of ever more globalization and financialization.

Now let’s turn to the list of current worries. According to the Financial Times and Bloomberg, it’s China. Their headlines, respectively: Fed warns ailing China real estate sector poses risks to US economy and China Property Stress Spurs Fed Warning as Bond Losses Widen .

While these headlines are narrowly correct, they give the impression that the Fed singled out China as representing a distinctively seroius yellow peril to America’s economic health. In fact, China is listed third. Here they are, in order:

A potential worsening of the public health situation may result in a reduction in business and household confidence, negatively affecting future economic activity and financial vulnerabilities…

A sharp rise in interest rates could slow the pace of economic recovery and lead to sharp declines in asset valuations and stresses at financial institutions, businesses, and households…

Stresses in China’s real estate sector could strain the Chinese financial system, with possible spillovers to the United States….

Adverse developments in other emerging market economies spurred by a sudden and sharp tightening in financial conditions could also spill over to the United States…

In Europe, a slower-than-expected recovery could trigger financial stresses and pose risks to the United States because of strong transmission channels

Moreover, if you read the section on China, you get the feeling that the Fed doesn’t really have a theory as to how blowback from China might occur, just that China is so big, if it went really pear-shaped, it couldn’t not affect the US:

In China, business and local government debt remain large; the financial sector’s leverage is high, especially at small and medium-sized banks; and real estate valuations are stretched. In this environment, the ongoing regulatory focus on leveraged institutions has the potential to stress some highly indebted corporations, especially in the real estate sector, as exemplified by the recent concerns around China Evergrande Group. Stresses could, in turn, propagate to the Chinese financial system through spillovers to financial firms, a sudden correction of real estate prices, or a reduction in investor risk appetite. Given the size of China’s economy and financial system as well as its extensive trade linkages with the rest of the world, financial stresses in China could strain global financial markets through a deterioration of risk sentiment, pose risks to global economic growth, and affect the United States.

Translation: the Fed does not see any direct transmission mechanism from China’s financial systems to ours. However, a domestic financial crisis could produce a sharp drop in trade. Suppliers in China are already getting slow payments on receivables, and many borrow to cover that. That contraction could blow back to other economies and their banks, and potentially propagate to the US, or more likely, directly whack confidence. Recall that there have been a couple of episodes of sharp downdrafts in Chinese financial markets, which typically lasted only two weeks, and markets abroad dropped in sympathy.

In fairness, one could argue that Bloomberg was using the Fed report as a hook for an update on souring conditions in China. From its article:

The cash crunch is worsening by the day. The yield on a Bloomberg index of Chinese junk dollar bonds — dominated by property firms — has surged toward 24%. Kaisa Group Holdings Ltd., which said last week it missed payments on wealth products, was downgraded further into junk by Fitch Ratings on Tuesday.

The selloff has spread to higher-grade issuers such as Country Garden Holdings Co., while even a company controlled by China’s government has seen its bonds slump. Spreads on the nation’s investment-grade bonds over Treasuries widened the most since April on Tuesday.

So Bloomberg only discussed the China section. The Financial Times led with China and devoted six out of fourteen paragraphs to it. Three were on meme stocks even though the Fed did not cite them as a “near-term risk” but instead had a special section them. The article inaccurately said the Fed’s domestic warnings were only a sharp interest rise and its impact on risky assets and housing. No mention whatsoever of the lead item, Covid risk.

By contrast, the Wall Street Journal put Covid front and center: Fed Says U.S. Public Health Among Biggest Near-Term Risks to Financial System The Journal did not mention China but stressed that Fed officials were concerned about elevated asset prices.

What is striking is that the Fed report mentioned supply chain problems all of once (to its credit, the Journal did pick up on that). From the Stability Report:

A possible deterioration in the public health situation could slow the recent economic recovery, particularly if widespread business closures returned and supply chains were further disrupted.

Note that the central bank sees supply chain problems as not a danger at their current level, nor a sufficient risk to create damage to the economy absent a resurgence of Covid.

Yet there is no indication the log jam in West Coast ports is getting any better. Lambert cited a Business Insider piece yesterday in which an intrepid reporter took a boat ride to see what was happening, and things were not better than on the earlier boat ride that described how little action there was.

We are getting reports that the crunch may be about to turn acute. As we report in Links, rural hospitals in flyover are not able to get crutches or walkers due to aluminum shortages. It’s easy to dismiss that more as a function of problems with trucks and trains, but one reader says a CEO in the industry says that the problem is not only widespread but also acute, and will go critical within two months. Even though aluminum is also recycled domestically, that equipment is fussy and prone to breakdown, and parts for them are in very very short supply. We are also hearing warnings about copper due to high quit rates in recycling plants and mines that rely on seasoned personnel where it is hard to bring on new staff. Operators are attributing it to vax resistance; the men work in close conditions in poor ventilation and know or believe they have already gotten Covid and resent being asked to take a shot now. The claim is they are getting out now while the job market is strong.

Mind you, these reports are anecdata, and aside from the story on shortages at one hospital, not independently corroborated. But this is the sort of story that could easily fall through the cracks. The financial press is very hollowed out, focused on big markets and big industries. Domestic processors are likely way below their radar. And insiders would not want to sound alarms if all that would do is cause buying panic.

So please be on the lookout for supporting or contrary data points. Either of these shortages would be a very big deal if they come to pass.

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  1. PlutoniumKun

    I can’t help thinking that the Fed and markets in general are significantly understating supply chain risk issues. I think there is an underlying assumption that somehow things will sort themselves out.

    China has been shutting down many base chemical/metal/fertilizer plants since the summer due to energy constraints. Many of these shutdowns aren’t going to work their way through food and manufacturing supply systems until next year. A lot of supply constraints will only show themselves when power stations or manufacturing plants grind to a halt because something breaks and then they discover there is a year long waiting list for the spare parts needed (this is already affecting power stations in Europe).

    Another risk I would see is that many industries have been ‘talking up their book’ to get them through Covid. Airlines and aircraft manufacturers, and all the related tourism infrastructure have been making enormously optimistic projections based on the assumption of ‘normality’ in 2022-23. At some stage, reality will strike, and it might strike hard enough to cause a major re-valuation of many markets.

    1. w d w

      i suspect that the US will also have its own power supply problem, if not where else, in Texas, cause even after the huge crunch back in February, the state hasnt addressed the problem yet. in spite of saying they had. but then a second crunch almost happened…in the spring??? the mildest time of the year????

    2. Rudolf

      Another anecdote: I have a close friend currently touring the country for the past few months. He told me that he has seen more semis on the highways, by far, than ever. This isn’t his first rodeo and he’s still amazed at the high volumes he’s encountering. Begs the question, doesn’t it ?

  2. Michael

    Definitely underestimating supply chain issues. And the resulting employment issues.

    Went couch shopping here in San Diego at Living Spaces, an 10+ store chain in So Cal. 100,000+ sf of cheap furniture. Wife wanted to go because they had some Made in America offerings. Floor models were 90% made in Mexico, some Vietnam.

    They had at least 50 roving ipad toting sales people plus desk jockeys where the sales were finalized. Offering no down 5 years of equal payments at only 10%. Enticing?
    We can deliver tmrw! Free! Some restrictions, not all models in fine print.

    Cruised over to higher end shop selling US products like Bernhardt from N Carolina.
    Prof sales woman said 6 month wait for everything! Demand backed up production, cuz after a year plus of Covid, everyone hates their furniture! But foam padding was the under the radar issue. Texas freeze did a number on the only US suppliers and they are holding up cars, rvs, boats, mattresses etc. Cascading problems.

    No product to sell means less employment in sales areas but shortage of skilled workers hampers production and increases costs.

    Dig deeper in any industry and you will find similar stories.

    1. cnchal

      There is a lot of fake demand. I went to my fastener store to buy some nuts and to make the transaction worth their and my time I wanted to add something useful to my order and I asked for some floor dry. The sales person asks “do I want two skids of floor dry” and then tells me that a customer ordered two skids but cancelled the order because it was late.

      See where this is going? The company that wanted two skids placed multiple orders at different suppliers and then cancelled when the first one could fill the order. Now there is lots of floor dry around locally that will take some time to be absorbed and the fastener store has cash tied up in stock that was not sold when they expected it to be.

      The next link in the chain, the floor dry makers (from Las Vegas – who knew) sees a spike in demand with huge orders coming in from everywhere without knowing that a huge portion of that demand is fake, and gears up to meet it. Their suppliers see the demand and don’t realize a lot of it is fake, and so on down the line.

      When recognition that too much was ordered is realized, orders stop and those that geared up to meet the fake demand will be in a big world of hurt, to put it mildly.

      Multiply my little foray to the store by the billions and we have the beer game writ large.

  3. redleg

    From a layman’s perspective: if the Fed is laser-focused on asset valuations, wouldn’t a failing supply chain be mostly irrelevant to the Fed, as the resulting price increases keep revenue constant even if sales are much lower? Or alternatively, are they counting sales as an asset and not (much delayed) delivery as a liability?
    I don’t think any of that’s true at all, but I’m not the Fed. I’m just trying to think of how layers of supply chain failures can be completely dismissed.

    1. w d w

      best guess? if they mention, what exactly can the Fed do about it? other than make noise that maybe some one else can or will do? since the ‘supply chain’ is all run by private sector actors, just who can do what?

    1. tegnost

      Yes, blame it on those stupid druggies….
      “The American Trucking Associations said driver shortages are around 80,000, citing a high number of retirements, a low number of female drivers and drug test failures. ”
      “A majority of the violations (56%) are for marijuana, which is legal in 18 states for recreational use and 36 states for medical purposes, but it is still considered a federal offense. Another 18% of cases are for amphetamine and methamphetamine violations, and cocaine and opioids account for 15% and 4% of drug test failures, respectively, the news outlet said.”

      Good thing they’re not testing wall st., those numbers would probably look great by comparison

      1. w d w

        no…that wouldnt happen…the lords of creation dont have to be tested for any thing,..and can do what ever they want when they want….

      2. lance ringquist

        thank another nafta democrat for the trucking problems, jimmy carter, who was warned that deregulation is a ticking time bomb. but jimmy hated unionized highly trained and payed workers. they cut into profits.

  4. dcblogger

    yesterday I went to LandsEnd to purchase a sweater and T shirt, they did not have any in my size. As in none at all. For me I just have to continue with my present supply of T shits and sweaters, but for LandsEnd it is a lost sale. I pity the people working to coordinate supply chains right now, their life must be miserable, what with all the pressure from above. In the near future this will create a terrible political crisis.

  5. chuck roast

    Yves, it pains me to see you mention Rogoff & Reinhart and their tainted study of international capital flows. These knuckleheads would have done better to focus on the volatility of international capital flows rather then the aggregate totals. But then they would have had to address sovereign control of international capital flows…a no-no for such corporate footstools.

    It is my understanding that the Plutocrat Boutique Bespoke Bank has a number of rusting tools in its tool box that could address the current mania of their constituents for wallowing in the punch bowl. For example they could have long ago raised the margin requirements on stock purchases. Unfortunately, Powell and is friends might have had difficulty putting together foursomes on Sunday mornings had he taken this course (no pun intended) of action. As a simple caddy, this is perfectly understandable.

  6. jim truti

    Why doesn’t the Fed just buy Evergrande’s debt and put in the Memory Lane?
    God forbid the stock market can go down 3%.

    1. MonkeyBusiness

      I suspect, they’ve made an offer to the Chinese behind the scenes. After all if the stock market were to go down 50%, I think this country is done.

  7. Susan the other

    Way over my pay grade. But I always feel like the Fed is actually on the job. Way too much is at stake for them to be eating cake. They claim to be focused on protecting “asset” prices. I think that’s a good position because the old world of money is disappearing fast. The new world of resources is here. Hard to make a point here, except to say that it might be a feature of their approach to allow a vast expanse of money to chase after assets and instead of controlling the money, control the price of assets by supplying a surplus of money so there’s always some out there to invest and keep asset prices up. Which in turn supports finance. How does the Fed control assets when its only mandate is keeping inflation down and employment up? A high-wire act. It floods the economy with money. It’s not the Fed’s job to police the economy. But when their outdated mandate reaches a crossroads where simple finance meets finance dependent on a new reality (resources) they have to gear up. Or something like that.

  8. lance ringquist

    capitalism can barely work if you understand this, demand for goods and services is wage driven.
    the deplorable must make enough money to consume, service their debts, save a little, and have enough leisure time to enjoy the fruits of their labors.
    nafta billy clinton did not believe that. he believed that chinese communist serfs would be the future consumers of the world, and the deplorable would just find another job.
    and the brain trusts of nafta billy clinton, greenspan, summers, and rubin said give them cheap money.
    of course how are they going to pay the money back when nafta billy clintons disastrous polices stripped the deplorable of their jobs, homes, wealth and pensions, and the ability of america to produce jobs that are meaningful and gainful employment, and in the end, the deplorable could not service that debt, and the whole house of cards collapsed in 2008.
    ben franklin said americans must be shielded from cheap labor competition, and that the american constitution was a high wage constitution.
    look at article one, section eight, and article six. tariffs, duties, excise taxes, regulation, capital controls easily fits into those categories.
    just think of what a UBI without production, protectionism and capital controls would do to inflation.
    we make so little, the infrastructure bill will most likely fuel even more inflation and supply chain chaos.

  9. Sound of the Suburbs

    Financial stability arrived in the Keynesian era and was locked into the regulations of the time.
    “This Time is Different” by Reinhart and Rogoff has a graph showing the same thing (Figure 13.1 – The proportion of countries with banking crises, 1900-2008).

    The neoliberals removed the regulations that created financial stability in the Keynesian era and the financial crises came back.

    They had learnt a lot after the Wall Street Crash, and the Great Depression, and knew what regulations they needed to put in place to bring financial stability.
    Much of this knowledge was lost, which is why today’s central bankers are unable to bring financial stability.

    The financial system is particularly vulnerable to the ideas that flourish with neoclassical economics. It was the same in the 1920s.

    What’s wrong with neoclassical economics?
    1) It makes you think you are creating wealth with rising asset prices
    2) Bank credit flows into inflating asset prices.
    3) No one notices the private debt building up in the economy as neoclassical economics doesn’t consider debt.
    4) The banking system and the markets become closely coupled, and as soon as asset prices fall it feeds back into the banking system

    What is the fundamental flaw in the free market theory of neoclassical economics?
    The University of Chicago worked that out in the 1930s after last time.

    Banks can inflate asset prices with the money they create from bank loans.
    Henry Simons and Irving Fisher supported the Chicago Plan to take away the bankers ability to create money.
    “Simons envisioned banks that would have a choice of two types of holdings: long-term bonds and cash. Simultaneously, they would hold increased reserves, up to 100%. Simons saw this as beneficial in that its ultimate consequences would be the prevention of “bank-financed inflation of securities and real estate” through the leveraged creation of secondary forms of money.”

    The IMF re-visited the Chicago plan after 2008.

    When you use the money creation of bank credit to fund the transfer of existing assets it inflates the price.

    This is a good example.
    What did Glass-Steagall do?
    Glass-Steagall separated the money creation side of banking from the investment side of banking. It also stopped the money creation side of banking from trading in securities.
    Without Glass-Steagall the bankers could create the money to buy securities they produced themselves in a ponzi scheme.
    There are intermediaries involved, so it’s not that obvious, but this is effectively what is happening.

    This is what they did before 1929 and 2008.
    “It’s nearly $14 trillion pyramid of super leveraged toxic assets was built on the back of $1.4 trillion of US sub-prime loans, and dispersed throughout the world” All the Presidents Bankers, Nomi Prins.
    They produced these toxic assets themselves.
    They traded them between each other, and used the money creation of bank credit to fund the transfers, pumping up the price.
    The ponzi scheme then collapsed in 2008, and as asset prices collapsed the banking system became insolvent until it was recapitalised with taxpayers money.

    The build up to 1929 and 2008 look so similar because they are.
    At 18 mins.

    1. lance ringquist

      but but nafta billy said the banks and wall street had learned, and we must have a 21st century financial system.
      what nafta billy really did was send us back to the late 1800’s.
      we got lots of money, no production which is the real wealth. we got no bananas today, but lots of dollars.

      1. Susan the other

        Clinton didn’t know what he was doing. He paid down the debt and tried to balance deficit spending thinking that would put things right but all it did was start the tail spin. Austerity is crazy. Austerity crushes demand first – and some of the damage trickles up. It’s economic mummification at its finest. But financiers used to think it was the most important thing in economics – to “keep the dollar strong” for international purchasing power. Now we’ve got the aftermath of all Clinton’s bad thinking and disastrous off-shoring and far less production capacity than we require, etc. So the Fed isn’t worried about the price of assets because they are going too high (maybe real estate is out over its skis but that might be a factor of having nothing else to invest in) – instead the Fed is worried that the price of assets will crash. The stock market is top heavy to say the least. But (without BBB) no investments are going out to the rest of the country. To cut back the money supply and force financial austerity on top of the GFC and Covid and climate change is simply insane. And even more insane when you stop to realize that money has no value whatsoever – money is simply a reflection of human cooperation which is valuable beyond words. Which is why we always go into communication default mode and just substitute the word “money”.

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