JANET Yellen has started weaning the American economy off its addiction to cheap money. But, given recent mixed economic data, economists are divided on the merits of the US Federal Reserve chair’s decision to raise interest rates by 25 basis points.

For a different perspective on the challenge facing the Fed, it is worth looking at another corner of Washington: the Office of Financial Research. Just before the Fed announcement, the OFR published its first Financial Stability Report on the health of US finance. This went largely unnoticed.

That is a pity. The OFR, an offshoot of the Treasury, was set up after the 2008 crisis to assess financial risk — and its report reveals that several years of ultra-low rates have distinctly the distorted financial system.

Ms Yellen will need extraordinary skill — and luck — to handle these distortions without sparking another crisis. The market reaction to the rate rise might seem impressively calm, but the real test for the wider financial system has barely begun.

In finance, there are at least three areas investors need to watch. The first is the fact that the ultra-loose policy has created credit bubbles that could now deflate. Because they have not emerged in the sectors that were at the centre of last decade’s bubble, mortgages and banks, they have attracted less attention. But, as the Bank for International Settlements wrote earlier this month, debt has increased significantly since 2008 in emerging markets.

Also, the OFR observed this week: “In our assessment, credit risk in the US non-financial business sector is elevated and rising” — to a point where “higher base rates may create refinancing risks . . . and potentially precipitate a broader default cycle”.

In recent years, asset managers have tried to chase yield by buying longer-term assets with greater credit risk. This has raised the ‘duration’ of bond portfolios — or their vulnerability to higher rates — to historic highs

Fortunately, banks seem fairly well placed to absorb losses. But an outbreak of defaults could spark contagion and market volatility, particularly since post-crisis regulations mean banks are less willing to be market makers in the non-business sector — prepared to buy or sell when investors want to trade — making it harder to trade the instruments in question.

A second area to watch is the state of investors’ portfolios. In recent years, asset managers have tried to chase yield by buying longer-term assets with greater credit risk. This has raised the ‘duration’ of bond portfolios — or their vulnerability to higher rates — to historic highs.

Indeed, the OFR calculates that a mere 100bp rise in long-term US rates could generate unhedged losses of $214bn for US-based bond mutual funds and exchange traded funds. Once again, the system as a whole could probably absorb this; but it could also spark contagion, particularly since banks, too, have increased their duration profiles.

A third area of concern is that in recent years there have been stealthy shifts in the opaque world of money markets. Before the crisis many asset managers, companies and banks placed spare cash in money-market instruments. Recently, however, this money has flooded on to the balance sheet of banks and the Fed itself. This has made it harder for the Fed to control the price of money with its usual policy tools.

Another effect of these flows in the money markets might cause the Fed rise to spark upheaval. Zoltan Pozsar, an analyst at Credit Suisse, thinks hundreds of billions of dollars could soon move back from banks to money market funds — with potentially destabilising consequences that the Fed (and others) are scrambling to understand.

These three points are not the only challenges in markets. Nor do they mean the Fed is wrong to raise rates now. On the contrary, the distortions have arisen precisely because money has been artificially cheap for so long. A rate rise was long overdue — at least for the financial world.

Nevertheless, nobody can ignore the fact that Ms Yellen and her colleagues are now walking a slippery tightrope. In coming months, Fed officials will need to convince investors and borrowers that the cost of money is finally rising at a steady rate and that they should adjust portfolios accordingly. (Arguably this has still not entirely happened: the markets are pricing in just two interest rate rises next year but Fed officials appear to expect four.)

The Fed also needs to avoid a replay of 1994, when it raised rates by more than 200 basis points, causing the 10-year bond yield to surge more than 300 basis points in a year. If that happened again, it would spark the defaults and bond fund losses of which the OFR warns.

What Ms Yellen needs for the financial system is a ‘Goldilocks’ policy, where market and Fed rates rise gradually, or at a speed that is ‘just right’. Better hope she can deliver that. Until then, applause is premature.

gillian.tett@ft.com

Published in Dawn, Business & Finance weekly, December 21st, 2015