By Desmond Lachman

The Federal Reserve has hardly covered itself in glory by having failed to anticipate recent major turning points in the US economy.

In
2008, the Fed got caught flat-footed by the Great Economic Recession. It was so
caught despite the dramatic once-in-a-century run-up in home prices and the
excesses in sub-prime lending that preceded it. In 2021, the Fed spectacularly
failed to anticipate the surge in inflation to a four-decade high. It failed to
do so despite the largest ballooning in the broad money supply in the postwar
period and the largest peacetime budget stimulus on record that preceded
surging inflation.

Today,
the Fed again appears poised to miss yet another major economic turning
point. This time in the form of a deep economic recession. It will fail to do
so despite the fact that we are currently experiencing the largest destruction
in financial market wealth in the postwar period and the quickest run-up in
long-term interest rates since 1994. It will also fail to do so despite signs
that we are on the cusp of an emerging market debt crisis.

Since
the start of the year, US financial markets have swooned in response to the
Fed’s shift to a more hawkish monetary policy stance to rein in inflation. Not
only have the NASDAQ and S&P 500 lost around 30 percent and 20 percent in
value, respectively, the bond market, too, has lost around 20 percent while the
cryptocurrency markets have lost some 70 percent.

The
steep decline in financial market prices is bound to have a meaningfully
negative impact on the economic outlook. It will do so by having wiped out an
estimated combined $15 trillion, or 70 percent of GDP, in household
financial wealth.

Using
the Fed’s rule of thumb that a $1 sustained decline in wealth leads to a
four-cent decline in spending, the financial market price declines so far this
year could result in spending being almost three percentage points of GDP lower
than it would otherwise have been. This is to be compared with a lengthy period
that preceded it when a positive wealth effect was providing support to the
economy.

Yet
another early warning sign that economic trouble lies ahead is the Fed-induced
run-up in long-term borrowing rates at their fastest pace since 1994. This
run-up must be expected to have a particularly large negative impact on
consumer demand for durable goods like cars and houses.

The
doubling of the 30-year mortgage rate from 3 percent at the start of the year
to close to 6 percent at present is bound to deal a body blow to the housing
market. If the average home buyer could afford a mortgage of $400,000 at the
start of the year, he can now only afford a mortgage of less than $300,000 at
today’s high interest rates. Little wonder then that we are already seeing
signs that the housing market is crumbling.

There
are also troubling signs from abroad. Indeed, our economy could be impacted by
an emerging market debt crisis in much the same way as it was adversely
affected in the late 1990s by the Asian currency crisis. According to the
International Institute of Finance, in response to high US interest rates
capital is being repatriated from emerging market economies at an increased
pace. This could be particularly problematic for those over-indebted emerging
market economies that are now being hit by a Russian-induced
international oil and food price shock.

All of this has to be a source of deep concern. By failing to heed the clear warning signs that we are headed for a recession, the Fed is slamming on the monetary policy brakes too hard to regain control over inflation. By so doing, the Fed is heightening the chances that we are in for a hard economic landing well within the next 12 months.

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