While measures of volatility in financial markets have fallen this week, the threat that the uncertainty generated by President Donald Trump's tariffs could tip into financial instability — with wild price swings leading to margin calls and disorderly selling — remains a worrying possibility.
Some, such as Ray Dalio of hedge fund Bridgewater Associates, even fear a “breaking down of the monetary order”, and a dramatic turn away from US Treasuries.
In the short term, neither the dread of a financial crisis, nor that of a deeper breakdown is warranted, for one reason: the US Federal Reserve is committed to ensuring US financial markets remain liquid and deep, and is willing to use its tools to do so.
In the March 2020 Treasury crisis at the beginning of the Covid pandemic and the 2023 regional banking crisis, the Fed extended huge amounts of liquidity to maintain orderly markets, taking considerable reputational and political risks.
Susan Collins, president of the Boston Fed, reiterated last week that the Fed would be ready to intervene quickly to restore order if necessary.
Not omnipotent
While the Fed’s guardianship is welcome in a highly volatile period for financial markets, it has its limits.
Market participants should not fall for pessimistic speculation, but nor should they be complacent.
First, financial stability is not asset price stability. The Fed will preserve market functioning, but it will not hold prices up. Yields could still surge and equities crater, only in an orderly manner.
Second, the Fed’s reach is limited. As we learned during Covid, it can do little to prevent deep dislocations in supply chains.
Tariffs could cause a hard stop in trade of some goods between the US and China, and broader repercussions are hard to predict.
Several economists and strategists see a US recession on the horizon. The Fed can do little to stop a recession not caused by financial conditions tightening.
Trump's shadow
Finally, if the Fed chooses to prioritise fighting inflation in a stagflationary environment, President Trump might be riled and attempt to remove Fed governors.
A forthcoming decision by the Supreme Court might give him legal room to do so.
In seeking to remove Cathy Harris from the Merit Systems Protection Board and Gwynne Wilcox from the National Labor Relations Board, the administration is expected to ask the Supreme Court to overturn a longstanding precedent set in the 1935 case Humphrey’s Executor v United States, which prevents the executive branch from removing the heads of independent agencies.
If the decision is overturned, President Trump would be free to reshape the Federal Reserve Board in his image.
And while a Trump-packed Fed might well choose to continue prioritising financial stability, the trustworthiness that allowed US financial markets to emerge as a safe haven for global investors would be gone.