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Is The Federal Reserve Destined to Start a Recession in 2023?

U.S. Economy
A U.S. $100 dollar bill is seen December 17, 2009.

Today’s strong jobs report numbers heighten the chances that next year the U.S. will have a hard economic landing in the form of a nasty recession. They do so by likely increasing the Federal Reserve’s resolve to barrel ahead with its aggressive monetary policy tightening. The Fed will do so even when cracks are emerging in the U.S. and world financial system and when the U.S. housing market already appears to have entered into recession.

Earlier this week, while paying lip service to the idea that monetary policy operates with long and variable lags, Fed Chairman Jerome Powell made clear that he thought it was premature to be thinking about any pause to the Fed’s current aggressive interest rate hiking cycle. Indeed, he suggested that to regain control over inflation, interest rates likely would need to stay high for longer and end at a higher level than he had initially anticipated.

A key part of the Fed’s justification for pursuing the most aggressive interest rate hiking cycle in forty years is that a tight labor market is causing wage pressure. That pressure in turn is raising the risk of a wage-price spiral and the un-anchoring of inflation expectations. Today’s job report, which showed a healthy 260,000 employment increase, a 3.7 percent unemployment rate, and a 4.7 percent increase in wages, will reinforce the Fed’s fears about an overheated labor market.

One reason to think that the Fed’s hawkish monetary policy stance could lead to a hard economic landing next year is that the Fed is not taking into account the long lags with which monetary policy operates. That is blinding it to the very strong likelihood that the full effects of its recent monetary policy hawkishness are yet to be felt.

In particular, the Fed does not seem to be anticipating that the more than doubling in mortgage rates from 3 percent at the start of the year to over 7 percent at present will throw the housing market into a full-blown bust. Nor does it seem to be anticipating that this year’s 15 percent surge in the dollar will lead to a marked widening in the country’s trade deficit next year.

An even stronger reason to fear that the Fed’s newfound monetary policy religion will lead to a hard economic landing next year is that the Fed seems to be forgetting that its earlier ultra-easy monetary policy stance in 2021 contributed not only to multi-decade high inflation but also to the US and world “everything” asset price and credit market bubble. Equity valuations reached levels seen only once before in the past one hundred years, U.S. housing prices exceeded the 2006 peak even in inflation-adjusted terms, and borrowing costs of highly leveraged borrowers and the emerging market countries reached record low levels.

The US and world “everything” asset price and credit market bubble were premised on the belief that interest rates would stay at ultra-low levels forever and that the economy would not succumb to recession. By continuing to raise interest rates to ever higher levels, the Fed would seem to be inviting the bursting of those bubbles. That could bring a deep recession in its wake.

Lending support to the idea that bubbles could burst due to ever higher interest rates are the large losses experienced this year in financial markets. Since the start of this year, US equity prices are down some 20 percent, bond prices are down some 15 percent, and the cryptocurrency market has lost around 60 percent in value.

More troubling yet are the cracks that are starting to appear in the world’s credit markets. Evergrande, along with twenty other Chinese property companies, has defaulted on their debts, the Bank of England has been forced to bail out the country’s pension system, Italian bond spreads are widening, and the emerging markets have started to default on their debt.

All of this has to make one wonder why the Fed persists in being a data-driven and backward-looking institution rather than one that looks ahead at the damage that its newfound monetary policy religion is going to wreak on the economy and the financial system.

Last year, that backward-looking bias led the Fed to keep monetary policy far too loose for far too long, thereby contributing to multi-decade high inflation. Now the Fed appears to be at risk of making the opposite mistake of being overly aggressive in its monetary policy tightening. That could lead to the further bursting of the “everything” asset price and credit market bubble, which could result in an unnecessarily hard economic landing next year.

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 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.

3 Comments

3 Comments

  1. Omega 13

    November 4, 2022 at 2:40 pm

    We’re in a recession. 2022Q1 and 2022Q2 had negative growth. That is a recession. Preliminary figures claim 2022Q3 had average growth (because we imported far less), but we’ll see if that’s revised downward.

    Or are you saying we’ll be in ANOTHER recession in 2023?

  2. pagar

    November 4, 2022 at 10:00 pm

    Biden and powell and yellen.

    Three old timer jokers.

    The jokers will send the whole world into a tailspin in 2023-2024 which is likely to prove fatal for many.

    Many national currencies will turn near worthless for poor nations as the almighty US dollar stages a super rocket ride into the stratosphere.

    Meanwhile arms manufacturers in the US will have the chance to make a killing as Biden turns on all the spouts to pour fuel onto the raging fire in Ukraine.

    Ww3 likely in 2023 with Biden flapping his sardine up and down while Jill watches in total amazement.

    Thus Biden is like the pied Piper of past folklore that allegedly led innocent kids to their doom.

    The US economy is one giant ultra mega super casino where cutting edge computer software and computer systems control everything, including gambling on high stakes, & endless speculation and manipulation on a near galactic scale.

    But Biden, powell and yellen totally have no idea of what’s going on and are using outdated methods to combat super Hi-Tech efforts to reap obscene profits by the super elite.

    Powell could at least cut down on the 24/7 printing of crisp fresh dollar bills but he hasn’t done anything of the sort. Instead he’s aiding Biden to spend the US and world straight to purgatory.

    It’s time for trump to return and give Biden a big kick in the behind and send him to the lake of fire.

  3. GhostTomahawk

    November 6, 2022 at 1:57 pm

    We are in a recession. The economy isn’t growing. Unemployment stats are rigged to give a rosy depiction. Inflation numbers are rigged to give us an impression of a less volatile situation than the one we see every moment of our day. Food energy and fuel are so high that it has literally wiped out middle America’s savings in less than a year turning Americans to credit cards to get by.

    Keep lying to us. Recession started the day Biden and the establishment reverted is back to the status quo in Jan of 21. That was the coups. Not Jan 6.

    Reap it.

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