Yesterday’s decision by the Federal Reserve to raise interest rates by 25 basis points rather than by 50 basis points was the right decision under the circumstances. However, that is far from saying that it will save us from a hard economic landing later this year as the price for the Fed’s egregious monetary policy mistakes in 2021.
The primary reason that the Fed finds itself in its present policy predicament of having to choose between reducing inflation and reducing financial market strains is that it kept monetary policy far too loose for far too long in 2021.
At a time when the economy was recovering well from the Covid-induced recession and was receiving its largest peacetime budget stimulus on record, the Fed maintained interest rates at their zero-lower bound and allowed the money supply to balloon. At a time when the stock market and the housing market were booming, the Fed chose to continue flooding the market with liquidity. It did so by buying $120 billion a month in US Treasury bonds and mortgage-backed securities.
The net result of the Fed’s monetary policy largesse is that not only did we get multi-decade high inflation. We also got an equity and housing market bubble and very poor credit market decisions, including those in the banking system.
Beginning in March 2022, the Fed belatedly responded to multi-decade high inflation with the most aggressive interest rate hiking cycle in the past forty years. That has taken a lot of air out of the stock market and housing market bubbles. More ominously yet, it has revealed serious problems in the banking system. The US Treasury and Fed have been forced to protect uninsured depositors in the Silicon Valley Bank and Signature Bank while a group of large commercial banks have had to prop up First Republic Bank.
All of this has put the Fed in an impossible policy position. Being data driven, the Fed feels that it needs to keep raising interest rates to bring down stubbornly high inflation. However, with a banking sector crisis in full view, it needs to lower interest rates to prevent further cracks from emerging in the banks that could lead to a full-blown credit crunch.
When it met yesterday, the Fed had three policy options. It could raise interest rates by 50 percent as earlier planned to show that it was serious about regaining inflation control. It could pause to take account of the possibility that the economy was heading towards recession as a result of the combination of past interest rate hikes and an unfolding credit crunch especially at the regional banks. Indeed, such a decision might have spooked markets which might have come to believe that the Fed knew that the banking sector crisis was worse than the market considered it to be. Alternatively, it could steer a middle course and raise interest rates by 25 basis points.
In the event, the Fed seems to have chosen its least bad policy option by raising interest rates by only 25 percent. However, one would have to engage in wishful thinking to believe that we will not see a rolling banking crisis later this year as more banks are found to have been swimming naked in the period of easy Fed money. One would also have to engage in wishful thinking to believe that the combination of a hawkish interest rate hiking cycle and a credit crunch at the regional banks will not lead to a recession later this year.
The moral of the story is that it would have been better had the Fed not been asleep at the wheel in 2021 when inflationary pressures were building and an asset price and credit market bubble was forming.
However, that would seem to be water under the bridge and it will be we who will be paying a painful price for the Fed’s blunders in the form of a hard economic landing.
Dr. 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.
March 23, 2023 at 3:23 pm
To answer the inquiry in the title:
This is due to a number of reasons but fundamentally is because the Fed premises its actions on mistaken conclusions derived from the application of a false economic doctrine: Keynesian Econ.
You see, Keynesianism mistakenly believes that central planners/central bankers can “stimulate the economy” and goose the GDP through open market operations and federal spending respectively. While this stimulus does have the effect of an adrenaline shot into an injured person, it is not the same as a permanent increase in strength, and the positive effects are transient. However, the negative effects are permanent, as the debt burden grows, the cost of borrowing increases to the gov’t on the fiscal side, and on the monetary side, the monetary base is expanded—BEYOND the corresponding rise in actual productive GDP growth. The Keynesians mistake government spent public sector “GDP” growth with actual private sector productive GDP growth, but the two are not synonymous.
The private sector GPD growth, if not malinvestment caused by government caused tsunamis of new cash, is real increases in productivity—which unless the monetary base is expanded commiseratively will result in deflation; but the public sector GDP growth is a burden being emplaced upon the private sector GDP. It is a net negative for the private economy, and has the effect of directing scarce resources via government fiat away from where consumers would most efficiently otherwise direct them.
This brings us to here… and now… the Fed raising interest rates doesn’t remove the vast monetary tsunami flooding and sloshing around the globe caused by the Fed’s financing the US Treasury/Fed gov’t’s fiscal profligacy. The difference between increases in the real, private sector GDP growth/position and the amount by which the monetary base has in fact been expanded WILL cause a destruction of this malinvestment in the market. This must occur. It is economic law. The things built on a false foundation without the privately generated long term productive capital to sustain their development will fail. And must fail.
So yes, a hard landing will and must occur.
March 23, 2023 at 4:02 pm
What tamed the inflation of the late 1970’s, was joint action by the the Federal Reserve and the Federal government. The Federal Reserve, raised interest rates to get the excess money out of the economy. I remember receiving as much as 12-16% from a checking account. On the other side, taxes were cut and government spending was cut. This one-two punch hurt for 2 years, but once the pain was over we had massive growth.
Right now, the Federal Reserve is raising interest rates. If that is enough or not enough, history will be the judge. But the government is raising taxes, and increasing spending, doing the exact opposite of what history has shown us works in taming inflation long term, and promoting growth and stability. Again, history will show if that is the right or wrong thing to do.
I do concur with the author on his conclusion. It would of been better to be a bit more aggressive in putting a damper on Inflation, not in 2022, but to start in 2021.
March 23, 2023 at 6:37 pm
The escalation in systemic inflation was caused by the Biden administration’s policies primarily focused on the supply and development of fossil fuels, leading to increased costs across the board fueling inflation.
Consequently to fight inflation the Fed thought it was prudent to ratchet up interest rates. Ending the decades of “easy money” and uncontrolled government spending. Now causing other unknown things to break in the economy as well.
I have heard it said that the Fed chair needs to be a rocket scientist. Someone with a great deal of economic wisdom and nuts and bolts experience.
Under our current leadership a rough landing now looks welcome versus an old fashioned depression that I have heard my parents tell about many years ago.
March 24, 2023 at 10:02 am
The Fed has been given free rein by biden the evil democrat politician-magician to dig a big, monstrously big hole for the ordinary american man in the street.
But that ain’t nothing compared to the hole biden is digging for the rest of the world.
Stoltenberg who’s biden’s top sidekick in brussels has urged europe to brace for a long war in ukraine.
Little does he know that the moment after the 2024 paris olympics ends, russia will immediately employ nukes to wipe out biden’s miserable foot soldiers and probably the rest of europe, too.
And in east asia, biden is upping the ante unaware or unbothered that north korea has already tested a new underwater nuclear devise capable of generating a tsunami powered by radioactive ocean water.
The hole(s) dug by biden outside of USA are massive enough to swallow every man, woman and child on the planet.
March 24, 2023 at 5:27 pm
Middle America already went splat
March 25, 2023 at 7:44 pm
Slowing the pace of rate increases now only means we will crash into the wall of recession at 70mph instead of 90mph.
March 26, 2023 at 3:01 pm
The government was not forced to make good on uninsured deposits. This was a move by Biden to cover the six of tech companies. A previous article on 19fortyfive has already pointed this out.
As for a hard landing, I am expecting things to not go well for the middle class.
March 29, 2023 at 10:00 pm
Far right lunatics ignore 3.6% unemployment, inflation reduced to 6% increased wages. AEI expects the sky to fall unless a conservative is making decisions.
March 30, 2023 at 9:46 pm
I appreciate HAT451’s historic perspective on the massive interest rate increases of 1978-79. Prime rate reached ~21%. I was in commercial lending & finance. Financed customers in building & building supplies with inventory loans at Prime+3, +4, simply called in and said “we’re going out of business, come liquidate your collateral”. Nobody could afford a loan to build.
One root problem is the inflation indicator is inaccurate and severely understates inflation.
How do we allegedly have “near zero inflation” during the ’03-’07 housing bubble and post bubble recovery ’15-’22 when housing prices are rising 20-to-30+% per year?
The reason is; in Reagan’s 1st term, the avg. cost of a mortgage/rent was removed from the Cost of Living Index.
If avg. cost of mortgage/rent were re-included, as housing prices rise, inflation indicators would rise, the Fed could apply policy to curb inflation on an ongoing basis – not at the “end?” of an inflationary cycle, as this article & fellow commenters noted. Powell notes the need to cool housing prices – but those prices are long arisen & out of control. (so, rhetorically, whaddya do? – force a recession & another bubble bust?) That’s how it seems, given that the indicators-of-inflation are broken gauges.