An error-prone Federal Reserve could plunge us into a recession
After the bankruptcy of Lehman Brothers in 2008 triggered the Great Recession, the Federal Reserve was widely criticized for sleeping at the wheel as a major economic crisis loomed.
Why had she paid so little attention to the housing bubble and the apparently obvious subprime lending problems that went with it?
Why was the clear message that Bear Stearns’ troubles in March 2008 sent about a strained banking system underestimated?
Given all the policy mistakes Jerome Powell’s Fed is making, one has to wonder if it will be accused of sleeping at the wheel again next year as another economic crisis loomed.
One might ask: without considering the long and variable lags with which monetary policy is known to operate, why has the Fed moved on after raising rates at its fastest rate in decades?
Why did she continue to ignore the dramatic fluctuations in the money supply she had caused?
And why has she largely ignored the financial market tensions her policies are causing and the emergence of a major economic crisis in China that could plunge the world into recession?
One of the Powell Fed’s defining characteristics is its pursuit of strictly data-driven monetary policy: each of its rate decisions is largely based on the latest economic data on wage and price inflation, economic growth and employment.
Not to mention that we know one thing about monetary policy: it takes between 12 and 18 months for interest rate hikes to have their full impact on the economy.
Knowing this, it would be wise for the Fed to wait before raising rates a full 5 percentage points in the short span of a year to see the economic impact of the rate hikes already made.
Milton Friedman famously taught that inflation is always and everywhere a monetary phenomenon.
Had the Fed heeded this lesson, it would not have paved the way for decades of inflation in 2022 by allowing the broad money supply to expand by an incredible 40% between early 2020 and late 2021.
Despite this experience, the Fed is now contracting the money supply at a rate unprecedented in the post-war period.
That could leave us with the opposite problem of major economic weakness and another period of flirting with inflation.
Earlier this year, several regional banks, most notably Silicon Valley Bank, failed due to large interest rate related losses on their bond portfolios.
At the same time, in a world of higher interest rates and high vacancy rates, where more and more people are opting to work from home in the post-COVID world, the troubled commercial real estate sector threatens to put further strain on the banking system.
This is particularly concerning given that $500 billion a year in such loans will need to be rolled over for the next two years.
But these looming problems in the financial system have not deterred the Fed from its new monetary policy religion.
It makes little mention of these risks in its policy statements and exacerbates these risks by continuing to raise interest rates.
In a recent moment of candor, President Joe Biden rightly described the Chinese economy as a “ticking time bomb” after the outsized housing and credit bubble burst.
China is the second largest economy in the world and until recently was the main engine of economic growth. The country’s looming economic crisis therefore has the potential to plunge the world into recession.
However, these real external economic risks hardly enter the Fed’s deliberations – underscored by the fact that Powell, in his recent Jackson Hole speech, did not even mention the Chinese economy as a risk worth watching.
If our economy slides into recession next year due to a series of serious policy mistakes by the Fed, rest assured: the Fed will make the defense that no one could reasonably have predicted the recession.
Desmond Lachman, Senior Fellow at the American Enterprise Institute, was Associate Director in the International Monetary Fund’s Department of Policy Development and Review and Chief Strategist for Emerging Markets at Salomon Smith Barney.
