The Fed could be about to make the same mistake it did before the financial crisis

“The risks of the Fed doing nothing are indeed real, and we look to be poised to repeat the same mistakes of the past.”

In a note to clients on Monday, John Silvia, chief economist at Wells Fargo, explores the risks the Federal Reserve is currently running by keeping interest rates pegged at 0% as it has since the depths of the financial crisis.

And in Silvia’s view, the Fed is running a major risk by doing one thing: nothing.

The longer the Fed does nothing, the more Silvia worries that we may be repeating the mistakes of the past. By repeating these mistakes, Silvia sees potential for us to once again head towards a major event in credit markets that, while not large enough to cause a global financial crisis, could, in Silvia’s view, majorly upset what have become fairly sanguine markets in the last several years.

Silvia writes:

We find the delay in Fed action concerning given the incentive effects of searching for higher yield and, in turn, the willingness of market actors to take on additional risk when interest rate expectations are flat […] We find that there are already signs of risk-taking behaviour and attribute at least part of this increase to easy monetary policy that has kept interest rates exceptionally low for a long period of time. In fact, short-term interest rates have been less than the rate of inflation for several years […] Our view is that the longer the Fed waits to raise interest rates, the greater the risk that these credit sectors become overheated and result in adverse economic effects.

In looking at the elements of the economy that could pose trouble if the Fed to continues down its same path, Silvia highlights four big things: merger volume, high-yield debut issuance, the easing of lending standards, and used auto sales.

Silvia notes that quarterly merger activity has tripled since the bottom in 2009 as the S&P 500 continues to grind higher.

While high-yield debt issuance is soaring.

General lending standards have declined as well, with Silvia noting that lending standards for a number of products are easier today than they were in 2006, while auto sales have started to see an uptick in those financed by sub-prime loans and a down-tick in those financed by prime loans.

Over the weekend, we wrote that Rick Rieder at BlackRock believes the Fed has an ‘epic, historic’ opportunity to raise interest rates. Rieder based much of this argument off the recent strength seen in the labour market.

But Silvia’s note also highlights another call for the Fed to act, one that is based on the potential that as-yet-unknown risks of six-plus years of zero interest-rate policy pose to the financial system.

“We do not feel that the current credit imbalances are enough to cause a global financial crisis,” Silvia writes, “as was the case with the housing boom and bust. However, should delinquencies begin to rise for subprime consumer credit products, this signal would likely be enough to result in anticipated future disruptions to credit markets.”

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