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The Federal Reserve Needs To Slowdown on Interest Rate Hikes

US Economy 2022
Image of US Currency. Image Credit: Creative Commons.

Today’s still solid jobs report, with unemployment at 3.5 percent and wages growing by 5 percent, offers little hope that the Federal Reserve will dial down its aggressive monetary policy stance anytime soon. That is a great pity. Further large interest rate increases, coupled with an unprecedented pace of quantitative tightening, risks further strengthening the dollar and roiling US and world financial markets. By doing so, it all too likely paves the way for a hard economic landing both at home and abroad.

A key policy mistake that the Fed is now making is to eschew Milton Friedman’s fundamental teaching that monetary policy operates with long and variable lags.

Instead of waiting to see the effects of the considerable amount of monetary policy tightening this year, the Fed is now adopting a data-based approach to determine when to stop tightening aggressively. Under this approach, the Fed’s policy is dictated by the actual data rather than any forecast as to where the economy might be headed.

In adopting a data-based approach to regain control over inflation, pride of place is being given by the Fed to the inflation and labor market data.  The Fed is doing so even though the unemployment data is what economists refer to as a lagging economic indicator. That is to say, unemployment follows rather than leads to what is actually going on in the economy.

With today’s jobs data suggesting that the labor market remains tight and that wage pressures are still strong, the Fed will find every reason to increase interest rates by another 75 basis points as planned at its scheduled November policy meeting. It will also find every reason to continue withdrawing $95 billion a month in market liquidity by quantitative tightening.

One risk of the Fed continuing along an aggressive tightening path is that it could sink the housing market. Already mortgage rates have more than doubled from less than 3 percent at the start of the year to almost 7 percent at present. That has caused mortgage applications to drop by 30 percent and housing affordability to become the lowest on record. It has also resulted in plummeting builder confidence and a sharp reduction in housing starts. Further interest rate increases could cause a major housing market recession.

Another risk of more monetary policy tightening is that it could put further pressure on a troubled stock market. Already with two US Treasury rates at over 4 percent, investors have an attractive alternative to investing in risky stocks. That alternative has contributed importantly to the approximately 25 percent decline in equity prices since the start of the year.

Further interest rate increases risks adding additional pain in the equity market. So too would the Fed’s persistence in withdrawing $95 billion a month in market liquidity. That would seem to be particularly ill-advised when consumer confidence is weak and when some $15 trillion, or around 70 percent of GDP, in financial market wealth has been wiped out since the start of the year.

Yet another way in which additional Fed tightening could damage both the US and global economies is by causing a further strengthening in the dollar. Over the past year, the dollar has appreciated by around 15 percent and is at its strongest level in the past 20 years. This is adding to inflationary pressure abroad. It is also increasing the cost of servicing dollar-denominated debt thereby pushing many emerging market economies to the brink of default. At home, it is reducing export competitiveness and crimping the dollar earnings of many US companies that have significant overseas operations.

If the Fed really wishes to avoid an unnecessarily hard economic landing, the best thing that it could do is to dial down the pace at which it is raising interest rates and it is reducing the size of its balance sheet. Unfortunately, after today’s still solid jobs report, the Fed is unlikely to do so 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.

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