History will not judge Jerome Powell’s Federal Reserve kindly. Aside from holding it accountable for a surge in inflation to June 2022’s multi-decade high of 9.1 percent, it will also ask why this year the Fed has stuck to a backward-looking monetary policy of high interest rates when a constellation of major economic risks was in plain sight. History will be particularly harsh if those risks lead to a hard economic landing.
Among the more immediate risks that the Fed is downplaying is the likelihood of a US regional bank crisis. Never mind that the Fed’s high interest rate policy has caused more than $1 trillion in mark-to-market-losses on the overall banking system’s bond and loan portfolios. Never mind too that the Fed’s high interest rate policy is exacerbating the slow-motion train wreck that is currently underway in the commercial property sector as a result of record high vacancy rates. Those high vacancy rates have been caused by the increased tendency of people to work at least part of the time from home and to shop increasingly online.
According to a recent National Bureau of Economic Research study, close to 400 small and medium-sized US banks are likely to fail as a result of high interest rates and an expected wave of commercial real estate loan defaults. If that were to occur, it would constitute a major headwind to the US economic recovery in much the same way as the 1982 savings and loan crisis.
The Fed also seems blind to the risk of a significant deterioration in the external economic environment. This would seem to be all the more inexcusable at a time when we have economic trouble brewing in a number of major countries and the risk of a widening of the Israel-Hamas war.
The Chinese economy is already slowing as a result of the bursting of its epic housing and credit market bubble. From being the world’s main engine of economic growth, China is at serious risk of experiencing a lost economic decade. Meanwhile, Japan’s fiscal day of reckoning appears to be on the horizon as underlined by the plunge in its currency to a 38-year low. The Bank of Japan (BOJ) now finds itself in a major monetary policy box that does not bode well for the Japanese economic outlook. If the BOJ does not raise interest rates, then the Japanese yen could go into a free fall. Yet, if the BOJ does raise interest rates, it risks making the country’s public finances even more unsustainable by raising the government’s borrowing costs.
Perhaps of more immediate consequence for the world economic outlook is France’s current political crisis following President Macron’s decision to call a snap parliamentary election. The strong likelihood of a hung French parliament is now drawing the market’s attention to both France and Italy’s unsustainable public finances. The Fed might spare a thought to the fact that France and Italy are the Eurozone’s second and third largest economies and are both many times the size Greece’s economy. A debt crisis in those countries could constitute more of a shock to world financial markets than did the 2015 Greek sovereign debt crisis.
Yet another risk that is already raising its ugly head is that of deglobalization, which could disrupt international trade flows. This trend would almost certainly be exacerbated were we to have a second Trump term. Mr. Trump has made clear that he would be tougher on Chinese imports than he was in his first term. He has also indicated that he would impose a 10 percent tariff on all imports. One has to expect this would invite retaliation by our trade partners that could take us further down the road to the destructive beggar-thy-neighbor policies of the 1930s.
If there is one thing that we know about monetary policy, it is that it works with long and variable lags. If the Fed waits for the risks to the recovery to materialize before it starts cutting interest rates, it will have waited too long to prevent a hard economic landing.
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