Deflation Will Become The Problem When “Something Breaks”

While the Fed continues to hike rates to combat high inflation levels aggressively, history shows that deflation will become a more significant threat when something “breaks” in the financial or credit markets.

As I discussed in a recent MarketWatch article:

“Stable markets can become unstable rapidly when something breaks due to rising rates or volatility. The Bank of England (BOE) is a current example of what happens when things go awry. The BOE on Wednesday was forced to start buying bonds to solve a potential crisis with U.K. pension funds. The pension funds receive margin when yields fall and post additional collateral when yields rise.

As they have recently, the pension funds are hit with margin calls, which have the potential to cause market instability. Due to leverage built up through the financial system, market instability can spread like a virus through global markets. That’s what happened in 2008 with the Lehman crisis.”

In the U.S., given the sheer magnitude of leverage throughout the financial system, we are likely well on the cusp of an even bigger “break” as Fed officials double down on the need to aggressively raise rates to fight what appears to be falling inflation regardless of the systemic consequences.

deflation, Deflation Will Become The Problem When “Something Breaks”

Those systemic consequences of the Fed tightening monetary policy have repeatedly occurred throughout history. The Latin American Crisis resulted from rising rates impacting dollar-denominated debt. That crisis could have rendered many U.S. banks insolvent. Rising rates triggered the 1987 Market Crash as “portfolio insurance” failed. Following that was a series of adverse events from the 1994 bond market crash, the Mexican peso crisis, Orange Country bankruptcy, Asian Contagion, Russian debt default, Long-Term Capital Management, the crash, and the Financial Crisis.