The Fed should anticipate trouble

Next week’s key Federal Reserve policy meeting will occur against the backdrop of considerable financial market strain, an incipient credit crunch and a looming debt ceiling showdown. If ever there were a time for the Fed to be more forward-looking and less data dependent, it has to be now.

If the Fed did become more forward-looking, maybe then it would pause its aggressive cycle of interest rate hikes and spare us from a hard economic landing.

The Fed helped us get into our current economic mess of multi-decade inflation and bursting asset and credit market bubbles by being overly data dependent in making monetary policy decisions in 2021. At a time when the country was receiving by far its largest peacetime budget stimulus on record, the Fed chose to keep interest rates at their zero lower-bound. It also chose to flood the market with a record amount of liquidity through its aggressive bond buying activity. It did so because inflation remained below the Fed’s 2 percent inflation target. That contributed to a record 40 percent money supply increase in the short space of two years and to a surge in inflation. It also led to the creation of bubbles in the equity, housing and credit markets.

Had the Fed been more forward-looking in 2021, it would have anticipated that excessive budget stimulus would in time have led to economic overheating. It would also have anticipated the consequences of the asset and credit market bubbles bursting. That in turn would have induced it to apply the monetary policy brakes well before March 2022.

Fast-forward to today. Instead of anticipating how a number of major risks that are in plain sight might precipitate a meaningful economic recession, the Fed chooses to be almost exclusively guided by lagging economic indicators like unemployment and inflation. It should know that the full effect of its most aggressive interest rate hiking cycle in the past 40 years is still to be felt on the economy.

The most immediate forward-looking event to which the Fed should be paying attention is the strong likelihood of a meaningful credit crunch in the wake of the recent Silicon Valley Bank and the Signature Bank failures. There is already clear evidence that regional banks are restricting credit. They are doing so to protect their balance sheets, which are overly exposed to real commercial property and interest rate duration risk.

The economy was slowing down even before the Silicon Valley Bank failure — a consequence of the lagged effect of the Fed’s aggressive monetary policy tightening and the fading of the Biden budget stimulus checks. A credit crunch in that context would represent the equivalent of an unwanted amount of monetary policy tightening that could very well tip the economy into recession.

A looming debt ceiling showdown, perhaps as early as July, is another major negative economic risk the Fed should be on the watch for. Such a showdown appears all the more likely given the hardening of House Speaker Kevin McCarthy (R-Calif.) and President Biden’s bargaining positions on this issue. McCarthy clings to his position that he will not support a debt ceiling increase without a commitment to deep public spending cuts. For his part, Biden insists that the ceiling should be raised with no strings attached to accommodate the spending increases that Congress already approved.

Judging from the negative market fallout from the 2011 debt ceiling showdown, going to the brink on this issue could be deeply unsettling for financial markets. Treasury Secretary Janet Yellen is probably right in asserting that all hell would break loose in financial markets if it was perceived that the United States might actually default, albeit only technically, on its debt obligations. This would be the last thing that we need at a time of a slowing economy, skittish financial markets and a rolling regional bank crisis.

All of this suggests that the last thing that the Fed should do next week is to add to financial market stress by raising interest rates another 25 basis points. However, given the Powell Fed’s tendency to make policy errors, I would not suggest betting the farm that it will do the right thing.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He 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.