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The U.S. Economy Keeps Shrinking: The Fed Should Slow Interest Rate Hikes Now

U.S. Dollars
A pile of U.S. currency. Image Credit: Creative Commons.

The Fed must back off aggressive rate hikes: So much for the Federal Reserve’s hopes that it can regain control over inflation while at the same time securing a soft economic landing. Now the fed has a serious problem on its hands it can’t easily solve.

It is not only that today’s dismal GDP numbers suggest that we now have had two consecutive quarters of negative economic growth. It is that there are all too many indications both at home and abroad suggesting that the Fed’s newfound anti-inflation religion is setting us up for a hard economic landing by year-end.

Among the clearer indications of rough economic sledding ahead is the decline in consumer sentiment to its lowest level on record. This should come as no surprise considering the many adverse shocks to which households are being exposed. A multi-decade high inflation rate is far outstripping the pace of wage increases. The Biden budget stimulus package has long since faded. And the worst first-half year equity and bond market performance in the postwar period has made a serious dent in household 401(K)s. All of this must spell trouble for future consumer spending, which accounts for more than two-thirds of US aggregate demand.

Almost every US recession has been led by a slump in the housing market. This is why the crumbling presently underway in the housing market should be grabbing our attention. In response to the Fed’s more hawkish monetary policy stance, 30-year mortgage rates have almost doubled from under 3 percent at the start of the year to 5 ¾ percent at present. That has made housing a very much less affordable to the average buyer than they were last year. This has been reflected in a more than 20 percent drop in mortgage applications and home sales over the past year and to a sharp drop in house builder sentiment.

As if there were not enough reason for concern, the US economy now faces strong headwinds from abroad. The Fed’s monetary policy tightening has led to surge in the dollar to its strongest level in the past twenty years. That is reducing our export competitiveness at a time when our export markets are being seriously constrained by poor economic performance in a number of major economies abroad. China’s economy has ground to a halt as a result of President Xi’s zero-tolerance COVID policy. Europe’s economy is being driven into recession by Vladimir’s weaponizing Russia’s natural gas exports and by renewed Italian political instability. Meanwhile, the heavily indebted emerging market economies appear to be on the cusp of a wave of debt defaults as capital is repatriated back to the United States.

In the past, serious economic stresses abroad have adversely impacted the US economy. They have done so mainly by unsettling our financial markets. This occurred in the 1980s with the Mexican peso crisis, in the late 1990s with the Asian currency crisis and Russian debt default, and in the 2010s with the Greek sovereign debt crisis. With all too many weak links abroad, we should brace ourselves for financial market problems ahead, especially in the largely unregulated hedge fund and equity fund parts of our financial system.

The real risk of a hard economic landing and of financial market stress should be raising serious questions at the Fed as to whether it has adopted too hawkish a monetary policy stance to contain inflation. That should be prompting the Fed to both slow the pace of interest rate hikes and to back off from its proposal soon to withdraw as much as $95 billion in market liquidity by not rolling over its maturing bond holdings.

However, given the Powell Fed’s record of doing too little too late on the monetary policy front, I am not holding my breath for this to happen anytime soon.

Author Biography and Expertise: Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund’s (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.

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Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund’s (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and multilateral lending agencies.

4 Comments

4 Comments

  1. Jim

    July 28, 2022 at 1:53 pm

    The “Goldilocks” approach is the best.

    Not too hot, not too cold… just right.

    Shock treatment might kill the patient.

    This is not the late ’70’s & early ’80’s, at that time the American Economy had more cushion (because the Fed had been relatively “conservative” leading up to the rate hikes and debt levels were much lower than today).

    America is highly leveraged, at present, in almost all sectors of its economy. All kinds of debt is hanging over us.

    A debt avalanche could be crippling.

    We gotta try and land this plane on a glide path.

    Assuming we could “do a belly flop landing” (sharp contraction on credit & growth) and then quickly recover, as some have said, is risky business.

    No, it’s as risky or more because if we “hit the tarmac too hard” and leave the plane severely damaged… structurally damaged… with long repair time.

    “Goldilocks” it is, if you can do it (“as long as you’re right”) … but do we have anybody on the bench (cockpit) that can hit the landing?

  2. cobo

    July 28, 2022 at 1:54 pm

    Suck it up, Desmond. Read your bio and weep.

  3. Jim

    July 28, 2022 at 3:46 pm

    Oil prices have been relatively stable, recently.

    That is key.

    Should Energy prices level off, as they have for the moment, inflation could taper off.

    That could spare the tough choices.

    Oil (being a proxy for Energy in total) price stability is key.

    Signals to the oil market that it’s okay to turn on the taps (allow drilling, pipelines, and refineries) with long-term guarantees & protections for capital investment would settle oil markets more than any dictate from the FED.

    And settle inflation more than any action the Fed could take.

    (Raising interest rates adds cost to business, thus to the inflation cycle… at one level of analysis.)

    And, this (political) crisis is about inflation more than anything else.

    The answer is staring you in the face, if you care to look.

    (Helping your friendly gas attendant when you fill your tank.)

  4. Scottfs

    July 28, 2022 at 6:23 pm

    Chaos in the marketplace is the price Democrats are very willing to pay to transition to a rent-based economy, you know, “you’ll own nothing and be happy…or else!”

    Slam the economy hard. A recession is exactly what is needed. With no money, people will be forced to ride the bus or walk… exactly what Democrats want. Equality in outcome is the only fair way. Work hard or sit in your ass…your pay is the same.

    It is all working as planned. Interest rates of 12-15% are perfect.

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