By Desmond Lachman

Among the more striking consequences of the Federal Reserve’s shift to a more hawkish monetary policy stance has been the swing in wealth creation from strong household wealth creation last year to rapid household wealth destruction this year. Yet despite past evidence that sustained changes in wealth do lead to changes in aggregate spending, the recent unusually large swing in household wealth is not getting the attention it deserves as another recession risk.

In early 2020, in response to the COVID-induced recession,
the Fed resorted to an ultra-easy monetary policy stance. That stance involved
both the reduction in its policy interest rate to its zero bound and to an
aggressive round of bound US Treasury and mortgage-backed securities buying in
the amount of more than $4 trillion. Those policies fueled the strongest stock
market rally in the post-war period as well as an unusually strong surge in
home prices.

According to the St. Louis Federal Reserve, largely as a
result of surging equity and home prices, household wealth increased from $116
trillion at the end of 2019 to $149 trillion at the end of 2021. This
implies that over a two-year period, household wealth increased by some $33
trillion or over 150 percent of GDP.

Fast forward to 2022 and we get an entirely different
picture as a result of the Fed’s start of an interest rate hiking cycle and a
move from one of flooding the market with liquidity to one of withdrawing
liquidity at an increasing pace. In the same way as the Fed’s bond buying last
year increased market liquidity, the Fed is now withdrawing market liquidity by
not rolling over its maturing bond holdings.

Since the start of this year, both equity and bond prices
have declined by 20 percent while exotic markets like those of cryptocurrency
have declined by some 70 percent. Meanwhile, as a result of a doubling in
mortgage rates from 3 percent at the start of the year to around 6 percent at
present, Goldman Sachs is anticipating an early end to the period of rapid home
price increases.

If sustained, the large decline in financial market prices
to date this year, coupled with a prospective leveling off in home prices,
could mean that some $15 trillion, or 70 percent of GDP, in household wealth
will have evaporated in 2022. This amount is a little less than the $18
trillion increase in household wealth created in 2021. This means that the
swing from wealth creation last year to wealth destruction this year will have
amounted to around 150 percent of GDP.

In the past, the Federal Reserve has estimated that a
sustained $1 loss in wealth leads to a three- to five-cent decline in aggregate
spending. Even on the basis of the lower bound of those estimates, it would
seem that the wealth effect could cause a swing in aggregate demand of around 4.5
percentage points of GDP between last year and this year.

Such a wealth-induced swing in aggregate demand could be
sufficient to push a vulnerable US economy into recession. Consumer demand
already is being affected adversely by high inflation, the housing market is
crumbling as a result of high mortgage rates, and exports are being constrained
by a strong dollar.

The prospect of a recession is particularly troubling in
that it could lead to another leg down in the stock market. That, in turn,
could further constrain aggregate demand through the wealth effect, which would
push the economy further into recession.

All of this would suggest that the Fed might wish to revisit its current policy shift towards a more rapid pace of interest rate hikes and aggressive quantitative tightening. Those policies might be the last thing that the country needs at a time when its financial markets are in disarray and when its economy is headed towards a recession.

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