Some Fed officials and staff are fretting about state of financial markets

By Michael S. Derby

NEW YORK, May 21 (Reuters) - When Kevin Warsh takes command of the Federal Reserve, he will do so as some central bank officials and staff have become increasingly anxious about the state of the financial markets and the risk that presents to the economy.?

Meeting minutes for the central bank's late-April Federal Open Market Committee showed that staff as well as a number of policy makers are showing some anxiety about the state of finances, as they wonder how they can shore up the already expansive suite of tools the Fed has in place to deal with market woes.

Even as the war in the Middle East has darkened the outlook, stock markets have booked strong gains that many struggle to square with economic fundamentals. Bond markets around the world have seen big rises in yields as investors fret about inflation and the government financing outlook. There's also increasing concern about how artificial intelligence investment is financed by debt, which increases the risk of market trouble should problems arise.?

That conversation, which transpired at the Fed's April 28-29 meeting, took place under the shadow of a looming changing of the guard at the central bank: Warsh is set to be sworn in as Fed chair on Friday, succeeding Jerome Powell, who will stay on for a time as a governor.

Warsh comes to the Fed as a critic of some of its key work over recent years, such as using aggressive asset buying as a tool to help calm markets in times of stress and to augment the stimulative power of its short-term interest rate target.

Warsh has also leaned toward a greater coordination with the Treasury Department in matters outside of monetary policy, which suggests possible changes for how the Fed uses its various liquidity tools to address financial stress.

Some fear the Fed will be less willing to step in in times of trouble and that the likely path toward accomplishing Warsh's desire for a smaller Fed balance sheet would actually increase risk in the financial system.??

NOTABLE VULNERABILITIES

In the meeting minutes, Fed staff "on balance continued to characterize the system's financial vulnerabilities as notable. The staff judged that asset valuation pressures were elevated." Fed staff seemed relatively sanguine on the state of household balance sheets but were worried about borrowing, most notably by hedge funds active in the government bond market.

Meanwhile, unnamed Fed policy makers shared at least some of that assessment.

"Several participants noted that asset valuations remained elevated and that such conditions heightened the possibility of sharp corrections should adverse developments materialize," while "many" officials noted concerns about private credit markets given the opacity of the sector.

The minutes said some Fed officials discussed "ongoing and potential operational improvements related to various liquidity tools" used by the central bank, including the discount window facility, standing repo operations and arrangements to provide dollars to other major central banks.

The minutes, in noting that officials voted to affirm the current currency swap lines, said "a few" Fed officials were interested in extending that arrangement beyond the current year, saying "a longer extension would be beneficial for financial stability."

Fed officials have been pressing for some time to get more deposit-taking banks prepared to use the discount window lending facility, its long-running and frequently stigmatized tool to extend fast credit to banks.

The Fed has also been tinkering with various arrangements for its repo operations, which loan cash to eligible financial firms. The Fed has encouraged eligible firms to use the discount window as needed, with the same guidance extended to the repo operations, which tend to see elevated demand during calendar-based market liquidity challenges.

Fed liquidity tools are aimed at stabilizing markets during times of stress and ensuring the Fed retains firm control of its interest rate target. Variations of these tools and policy strategies have gotten notable workouts in recent years, amid the COVID-19 pandemic and the banking crisis that happened in the spring of 2023.

While the Fed has defended its tool kit-New York Fed System Open Market Account Manager Roberto Perli said on Tuesday that the current system ?"is demonstrably very effective"-others have criticized the entire regime and it's unclear where Warsh stands on the matter.

The interlinkage between the Fed's various tools, which help bind short-term rates, would be hard to dismantle piece by piece, and a return to the system the Fed used before the start of the financial crisis nearly two decades ago would be very challenging and take a long time to accomplish, in the view of many observers and current central bankers.

(Reporting by Michael S. Derby; Editing by Chizu Nomiyama )