As the two U.S. presidential candidates plan to further increase trillions of dollars in deficits, the Federal Reserve faces risks beyond its lender of last resort function, potentially becoming a pillar relied upon by the market even in normal times.

The concept of lender of last resort was first theorized by 19th-century economist Walter Bagehot, who believed it was necessary to prevent bank runs.

Since the 2008 financial crisis, with the expansion of the Federal Reserve's balance sheet and the new tools established to support the market, its role in the market has significantly increased. This is also reflected in the rapid growth of the U.S. bond market, which has more than doubled in the past decade.

On September 30, the so-called Standing Repo Facility (SRF) was tapped for 2.6 billion U.S. dollars, marking the latest panic since the establishment of this instrument in 2021.

This tool allows certain lending institutions to borrow by pledging government bonds, aiming to alleviate cash shortages in the market that could lead to sudden spikes in short-term interest rates, threatening financial stability. However, two anonymous banking sources and a market expert stated that there were no liquidity issues that day, and financial stress indicators were below normal levels.

These individuals pointed out that the drawdown of funds highlights a serious structural issue: the U.S. bond market has become excessively large, reaching approximately 28 trillion U.S. dollars.

This is a potential problem that could worsen. The U.S. fiscal deficit is growing. Earlier this month, a budget-focused think tank estimated that Trump's tax and spending plans would increase the deficit by 7.5 trillion U.S. dollars over 10 years, while Harris's plan would increase the deficit by 3.5 trillion U.S. dollars.

Currently, the Federal Reserve and market participants have been proposing various ideas, which will further deepen the Federal Reserve's intervention in the market.

Although the smooth operation of the U.S. bond market is crucial for global financial stability, the increasing participation of the Federal Reserve may bring unexpected consequences, such as squeezing out other investors and creating asset bubbles, similar to what happened during the COVID-19 pandemic.

Darrell Duffie, a U.S. bond market expert and finance professor at Stanford University, said: "This is a serious issue. We must redesign the financial system and regulatory framework so that the market can digest liquidity demands on stressful days, and we have not reached that point yet."

The Federal Reserve is facing a series of bad choices, cornered by decisions of the fiscal authorities. Former Deputy Governor of the Reserve Bank of India, Viral Acharya, stated that this issue is starting to resemble situations in emerging markets, "because deficits are soaring, the borrowing schedule is too aggressive, and there are mismatches - but importantly, there is friction between private liquidity supply and demand."

Acharya, now an economics professor at New York University's Stern School of Business, said: "Therefore, the Federal Reserve must now put out fires on multiple fronts."

Editor/rice