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Backward-looking Fed is missing key recession risks


The Powell Federal Reserve’s fundamental weakness has been its tendency to look in the rearview mirror rather than at what lies ahead.

This helped get us into our inflation mess.

It now threatens to produce a hard economic landing while we’re the midst of a regional-bank and real-commercial-property crisis — and could soon be facing an economically damaging debt-ceiling showdown.

The Fed’s monetary policy in 2021 was guided by its fear inflation would remain stuck below its 2% inflation target.

That induced the bank to keep interest rates at their zero lower-bound and flood the market with $120 billion a month in liquidity through its bond-buying program.

In the process, the Fed allowed the broad money supply to increase by a staggering 40% over a two-year period.

It also created a housing, equity and credit market bubble.


The Fed created several bubbles that threaten the US economy.
REUTERS

By being fixated on inflation being too low and looking almost exclusively backward, the Fed somehow managed to miss the inflationary consequences of the $1.9 trillion American Rescue Plan Congress approved in March 2021.

That stimulus came on top of the previous year’s $3 trillion bipartisan stimulus response to the COVID-induced recession.

This cumulative stimulus of more than 20% of gross domestic product was by far the largest peacetime stimulus on record.

Yet the Fed still maintained an extraordinarily easy monetary policy.

As we painfully experienced last year, this combination of ultra-easy policy and massive stimulus led to economic overheating.

Little wonder then that inflation surged to 9.1% by June 2022, a level last seen in the early 1980s.

Fast forward to today and the Powell Fed is continuing to look in the rearview mirror.

It’s following a strictly data-dependent policy to bring inflation back down to its 2% target at all costs.

In that task, it’s being guided by what’s happened to past wage and price inflation.

Meanwhile, it is paying little attention to the real risk we could be headed soon toward a meaningful recession.

In its fixation with inflation, over the past year the Fed has raised interest rates at the fastest pace in the past 40 years.

It has also pursued an unprecedentedly aggressive quantitative-tightening policy that has withdrawn $95 billion a month in market liquidity.

It’s done this in disregard of the long lags with which monetary policy is known to operate and despite the fact the broad money supply is contracting now at a worrying rate.

The Fed has also continued to increase interest rates when inflation has already decelerated for 10 consecutive months to less than 5%.

Looking ahead, a number of senior Fed officials, including St. Louis Fed President James Bullard and Fed governor Michelle Bowman, are putting us on notice that the bank might need to raise rates further if inflation remains sticky and the labor market remains strong.

New York Fed President John Williams declared last week that “we haven’t said we’re done raising rates.”


A general view of a Christie's International Real Estate for sale sign in front of a house in Wyckoff, NJ on May 12, 2023.
Inflation surged to 9.1% by June 2022, a level last seen in the early 1980s.
Christopher Sadowski

Making the Fed’s newfound monetary-policy religion all the more difficult to understand is that the bank’s own Financial Stability Report warns that the ongoing regional-bank crisis could lead to a sharp contraction in bank credit.

Were that indeed to occur, it would have the same type of cooling effect on the economy as further rate increases.

The Fed’s aggressiveness is also puzzling because the gulf between President Joe Biden and House Speaker Kevin McCarthy’s positions on the debt ceiling show no sign of narrowing.

This has to be of deep concern when Treasury Secretary Janet Yellen is warning the debt ceiling could be breached by as early as next month and we could face a financial-market “catastrophe” if the US government were to default on its debt obligations.

In March 2008, then-Fed Chair Ben Bernanke failed to anticipate that the subprime mortgage crisis would lead to the Lehman bankruptcy and the Great Recession.

The Powell Fed seems to have learned little from that experience about the importance of looking ahead rather than in the rearview mirror.

It’s clinging to an aggressive policy even as the odds are increasing that a regional-bank crisis and a debt showdown could trigger a painful recession that would make inflation the least of our economic problems.

American Enterprise Institute senior fellow Desmond Lachman was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging-market economic strategist at Salomon Smith Barney.



This story originally appeared on NYPost

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