A dysfunction in financial markets risks undermining the effectiveness of the Federal Reserve’s monetary tightening tools, a senior U.S. central bank official has warned, amid growing calls for sweeping reforms to the $24 billion Treasury market. dollars.
Speaking at an annual Treasury market conference on Wednesday, New York Fed Chairman John Williams stressed the need for the central bank to continue its aggressive efforts to rein in historically high inflation – which have included aggressive interest rate hikes and a rapid liquidation of its balance sheet of around $8 billion – while simultaneously finding solutions to strengthen the resilience of the financial system.
“For monetary policy to be more effective, financial markets need to function properly,” he said. “Monetary policy influences the economy by affecting financial conditions, with the treasury market at the center of it all. If the treasury market is not working well, it can impede the transmission of monetary policy to the economy.
He added: “Now is the time to find solutions that strengthen our financial system without undermining our monetary policy objectives.”
His comments come at a tenuous time for the world’s largest bond market. Liquidity, or the ease with which traders can buy and sell bonds, has deteriorated significantly as the Fed has tightened monetary policy aggressively this year to contain inflation.
Treasury yields move with interest rate policy, and volatile yield action this year, along with uncertainty about the Fed’s future path, has made it harder and more expensive to buy and sell. sale of bonds. The concern is that low liquidity could lead to even more pronounced market volatility, increasing the risk of a financial crash.
A long-standing set of structural shortcomings that have made shocks in what should be a global safe haven become commonplace further undermine the functioning of the Treasury market, from which all securities are priced.
That prompted repeated calls for a regulatory overhaul — something the Fed, Treasury Department, Securities and Exchange Commission and Commodity Futures Trading Commission have sought to push forward since a “flash crash” in 2014 during which the prices of all maturities fell dramatically.
The fragility of the market was last revealed in March 2020 when fears of a pandemic sparked a chaotic race for silver that sent prices soaring. This made it nearly impossible to trade, with broker screens sometimes going blank as liquidity evaporated, and the Fed was forced to intervene.
Williams acknowledged on Wednesday that the size of the Treasury market has grown significantly over the past few decades and market players that were once major players have shrunk, contributing to past market shocks, previous research shows.
Primary dealers, the banks that buy bonds directly from the Treasury and were historically the main market players, have retreated since post-crisis regulations passed in 2010 made it more expensive for them to hold bonds on their balance sheets. High-speed traders and hedge funds have since stepped in to take their place, but have operated differently from banks.
Williams on Wednesday called on the private sector to do their part to help “build” market resilience. “[That] means planning to build resilience against episodes of volatility that can hurt market liquidity and preparing for times when funding is less certain, such as year-end,” he said. “And that means being a source of strength for the financial system and the economy, not a weak link.”
The Fed has introduced new tools in recent years to bolster the government bond market, including two standing facilities that allow certain domestic and foreign investors to exchange their Treasury holdings for cash. Over the past two years, regulators have proposed a series of reforms that would improve market transparency and subject hedge funds and high-speed traders to regulatory scrutiny.
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