History will not judge the Powell Fed kindly

It would be an understatement to say that the Federal Reserve has a poor forecasting record. Last year, the Fed kept assuring us that inflation would soon come down to its 2 percent inflation target. It did so only to find that consumer price inflation accelerated to a 40-year high of more than 8 percent.

This year the Fed keeps assuring us that it can bring down inflation while achieving a soft economic landing. It is doing so even though consumer price inflation has remained stuck at an unacceptably high level and the economy is showing every sign of heading for a recession within the next 12 months. 

Last year, the Fed’s underestimation of the inflation risk led it to maintain an excessively expansive monetary policy stance. Not only did that stance result in an inflationary surge. It also led to the creation of an equity, housing and credit market bubble.

In 2021, at a time when the U.S. economy was recovering strongly and receiving its largest peacetime budget stimulus on record, the Fed chose to keep interest rates at their zero lower bound and to allow the broad money supply to increase by 40 percent over a two-year period. Similarly, as the equity and housing markets were on fire, the Fed kept adding $120 billion a month in market liquidity through its Treasury bond and mortgage-backed security-buying activities.

In addition to fueling inflation, last year’s monetary policy largesse led to nosebleed high equity valuations by the end of 2021 that had been experienced only once before in the past 100 years. It also led to record-high housing prices that exceeded those in 2006 even in inflation-adjusted terms. 

Now the Fed seems to be making the opposite policy mistake. In much the same way as last year it maintained too easy a monetary policy as inflation was accelerating, today it is slamming on hard the monetary policy brakes at a time when the economy is slowing and the financial markets are slumping.

It is doing so by raising the rate at which it is hiking interest rates to 75 basis-point steps rather than the more normal 25 basis-point steps. It also is doing so by withdrawing market liquidity at a rate that will rise to $95 billion a month in the fall by not rolling over its maturing bond portfolio.

One reason to think that the Fed’s shift to a more hawkish monetary policy stance could bring on a recession is that it has already caused the asset and credit market bubbles it created last year to burst. Since the start of the year, equity prices have fallen by around 25 percent, bond prices have declined by more than 20 percent and the cryptocurrency market has lost around 70 percent of its value.

These declines have resulted in a cumulative loss in household financial market wealth of some $15 trillion, or 70 percent of GDP. Using the Fed rule of thumb that for every $1 loss in wealth, households reduce spending by 4 cents, the decline in asset prices to date could result in consumers cutting back spending by 3 percentage points of GDP.

Such a prospectively large decline in consumer spending is the last thing that an already slowing U.S. economy needs. This is especially the case at a time when fiscal policy has become restrictive and when the housing market is crumbling because of a doubling in mortgage rates since the start of the year.

Another reason to fear that the Fed’s newfound monetary policy hawkishness might be putting us on the road to recession is that it is causing capital to be repatriated from the emerging market economies at an accelerating pace. That repatriation is likely to lead to an emerging market debt crisis, especially in countries that are heavily reliant on oil and food imports.

All of this suggests that history will not judge the Powell Fed kindly. First it gave us multi-decade-high inflation by being asleep at the wheel when the country was receiving its largest peacetime budget stimulus on record. Now it is very likely sending the economy into a hard landing by slamming on the monetary policy brakes too hard when the economy is slowing and the financial markets are reeling.

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