Newspaper article International New York Times

After Years of Stimulus, Fed Still Faces the Unknown ; Tighter Monetary Policy Could Expose Fault Lines in the Financial System

Newspaper article International New York Times

After Years of Stimulus, Fed Still Faces the Unknown ; Tighter Monetary Policy Could Expose Fault Lines in the Financial System

Article excerpt

While most experts don't expect that an increase in interest rates will lead to 2008-style instability, tighter policy could expose frailties in the financial system.

The moment that Wall Street has long been dreading could happen this week.

On Thursday, the Federal Reserve may increase American interest rates for the first time in more than nine years. An increase would be the beginning of the end of a monetary stimulus policy that lifted stock and bond markets to new heights and brought the good times back to Wall Street after the crash of 2008.

History, however, shows that booms financed with cheap money often leave the financial system weaker, not stronger. And the fault lines start to become obvious only when the Fed starts to tighten monetary policy.

This time around, most analysts aren't expecting 2008-style instability, unless, say, China's economic problems worsen sharply. The Obama administration's overhaul of Wall Street appears to have made the largest banks more resilient to the sort of stress that can follow an increase in interest rates.

"I believe that Wall Street is better prepared for a market event than it was in 2008, partially as a result of regulation but, more importantly, as a result of experience," said Arthur Levitt Jr., a former chairman of the United States Securities and Exchange Commission.

A liftoff in rates may not happen this week. After a violent downturn in global stock markets last month, prompted by concerns about China, traders are now betting that the big event is more likely to happen at the Fed's December meeting.

But an increase in rates, whenever it comes, could still roil markets, make it harder for many businesses to raise money and expose new frailties in the system that postcrisis regulations have not properly addressed.

In theory, a small increase in interest rates -- the Fed is expected to raise them by only a quarter of a percentage point this year -- should not be enough to wreak havoc. If the real economy is reasonably healthy and corporate earnings continue to grow steadily, which seems possible, then stock and bond prices should not be vulnerable.

Still, some analysts have a darker view of the links between the Fed's $3.5 trillion stimulus, Wall Street and the wider economy. They say that financial markets have played a central role in funneling trillions of dollars into investments that will prove unsustainable when interest rates go up.

"The Fed is supposed to remove the punch bowl just as the party gets going," Albert Edwards, a strategist with Societe Generale, wrote in an email exchange. "It is already well past midnight, but the guests will keep partying until they drop if you ply them with even more alcohol."

And signs of excess abound.

Technology companies have been able to raise large sums even before they tap the public markets. This is a sign that investors are so hungry for a stake in the latest boom in Silicon Valley that they are willing to tolerate long waits before they can sell out and are willing to forgo more detailed financial statements.

The debt markets have long appeared overly eager to lend. Around the world, companies with a credit rating that is B or lower -- the less creditworthy of the junk bond issuers -- have sold debt worth $1.24 trillion since the start of 2009, when the Fed's stimulus began in earnest, according to data from Thomson Reuters. That sum is nearly three times the total for the 10 years before 2009.

At the same time, low interest rates have made investors more willing to buy stocks at historically high valuations. The low rates have also made it cheaper for companies to borrow money they can use to buy back their own shares. Repurchases of stock can bolster a company's earnings per share -- an important measure of a corporation's profitability -- because they reduce the number of shares outstanding. …

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