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.