Zachary Cefaratti and Ben Bernanke anticipated market challenges of eventual fed tightening as early as 2020

Taking little time to spill over into financial markets, dislocations in Treasury and investment-grade corporate bond markets became evident in March 2020, with yields increasing sharply and more dramatically than credit default swaps. Foreign central banks, bond funds, and hedge funds began disproportionately selling Treasuries, sparking a liquidity run.

Normally a key source of liquidity, dealers and market makers were unable to provide the necessary liquidity as a result of regulatory constraints and risk limits. The Fed recognised that intervention was immediately imperative. Rates were cut to near-zero, a quantitative easing program was announced, and numerous facilities were opened to stabilise a tumultuous economy.

Further economic stimulus and financial stabilisation policies were initiated by Congress through a variety of relief packages to aid the effectiveness of the Fed’s monetary stimulus and emergency lending initiatives.

The pandemic also resurfaced the predated issue of increasing financial fragility and the risks of globally interconnected financial systems. Since the 2008 financial crisis, economists have become vocal about the sensitivity that future destabilising events would have in an environment of extraordinarily loose monetary policy and accumulating debt in developed nations.

However, concerns over rising sovereign debt were overshadowed by a decade of rising asset prices and strong, sustained economic growth. While there remains much debate over the implications of rising debt on the health and stability of a nation with sovereignty, it became clear in the early stages of the pandemic that the rapid accumulation of private debt by non-financial institutions (due to the growth of volatile foreign and domestic shadow banking institutions – which were only marginally curtailed through various legislation in the aftermath of the 2008 financial crisis) would contribute to pressures in US dollar funding markets, given the US dollar’s prevalence in foreign debt denomination and transactional flows.

Zachary Cefaratti hosts Bernanke for exclusive YPO session while the covid crisis unfolded

As 2020 came to an end, there was no shortage of economic and financial uncertainties present amongst market participants and policymakers. Making sense of and appropriately managing these issues became paramount to survival in markets. With the goal of initiating a platform through which global financial leaders could collaborate and effectively navigate the Covid-19 crisis, Zachary Cefaratti, founder of Dalma Capital and AIM Summit, launched a five-part economic webinar series on behalf of the Young Presidents’ Organization (YPO), of which he is a Member of the YPO Emirates chapter.

Beginning with Dr. Ben Bernanke in March 2021, Zachary interviewed five renowned central bankers and economists in front of a global YPO audience, including Nouriel Roubini, Stephanie Kelton, Joseph Stiglitz, and Mark Carney. While each interview had a different agenda catered toward individual specialties, they ultimately shared the same underlying theme – the implications that monetary and fiscal policy decisions would have on the economic and financial outlook and the unique challenges brought on by the pandemic.

The session with Bernanke was particularly insightful, as he drew on his personal experiences as Chairman of the Federal Reserve during the 2008 financial crisis and deep knowledge of the Great Depression to highlight the key differences between those two prior events and the 2020 crisis.

Asking about the differences in the toolkit used by the Fed to combat strains in financial markets, Bernanke indicated that the Fed largely built off many of the same levers that were introduced and utilized in 2008 – such as Treasury, MBS, and corporate bond purchases, as well as US dollar swap lines and emergency lending to primary dealers – but on a much larger and more proactive scale.

Unlike 2008, however, Bernanke spoke of the Fed’s additional need to act as a market-maker of last resort to fill gaps left by traditional liquidity providers and the necessity for heightened intersectoral action resulting from a unique sectoral mix (predominantly services) being disproportionately affected by the coronavirus.

Looking forward to policy normalisation and referencing the 2013 taper tantrum in which heightened market volatility hit emerging markets particularly hard, Zachary Cefaratti asked about “how investors should consider the risk of taper tantrum as the Fed ultimately seeks to normalise policy, and how the Fed would better manage their slowdown in asset purchases through more effective forward guidance.”

Bernanke responded by expressing his surprise that “the Fed provided guidance on quantitative easing that was, in essence, very qualitative,” and thus, not tied to “certain numerical conditions being met,” which was very similar to the Fed’s approach in 2013. This vagueness contrasted with what Bernanke had thought the Federal Reserve had learned in the aftermath of the 2013 taper tantrum episode, whereby investors had “misunderstood what the Fed’s plans were, leading to miscommunication with the markets.”

With that being said, Bernanke also noted that, in 2013, market participants “tied QE and rate guidance too closely together, leading investors to assume that a slowdown in QE suggested an increase in rates would occur almost immediately” and that “the Fed has now tried to separate QE and rate guidance and has been very explicit that it wouldn’t raise rates until inflation targets were met,” limiting the risk that assumptions in rate hikes would be immediately inferred once QE tapering begins.

As the session with Zachary Cefaratti and other leading participants came to a close, it was made clear to viewers that the Federal Reserve remained steadfast in its determination to leverage monetary policy actions of greater and more wide-ranging magnitude to ease pressures in future financial crises, whether through larger and more expansive asset purchases or more intensive lending facilities, thus presenting heightened awareness of moral hazard with prospective implications on regulation and macroprudential policy.