The Fed is playing with fire with its continued interest-rate hikes

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The stock market’s thumbs down to last week’s Federal Reserve policy meeting should serve as a stark reminder to the Fed of the serious financial-market risks it’s running by clinging to its hawkish monetary-policy stance.

By committing itself to continued interest rate hikes even as the economy is moving toward recession, the Fed is inviting real trouble in the equity, housing and credit markets. How quickly the Fed seems to have forgotten the lessons from the 2008 Lehman crisis.

The worst macroeconomic environment that can challenge the stock market is one of rising interest rates, an economic recession and a strong dollar.

Higher interest rates on short-dated US Treasury bonds offer investors a risk-free interest-bearing alternative to holding risky stocks. They also constitute a higher rate at which company earnings are to be discounted. An economic recession, meanwhile, has the effect of compressing corporate earnings, while a strong dollar reduces the dollar value of overseas corporate profits.

Yet this is precisely the kind of challenging environment the Fed is creating by its newfound monetary-policy religion.

The stock market reacted negatively to the latest Federal Reserve meeting.
The stock market reacted negatively to the latest Federal Reserve policy meeting.
Photo by Spencer Platt/Getty Images

Last week’s Federal Open Market Committee meeting left little doubt that the Fed intends to continue raising interest rates to more than 5% by end-2023 following last year’s most rapid rate increases in 40 years. The Fed would do so even when the housing market is showing every sign of already being in a recession and consumer demand is now flagging. The Fed has made clear it will stop raising rates only once it sees the clearest of signs that inflation is coming down towards its 2% inflation target.

Any further equity-market decline could heighten the chances of a meaningful economic recession by delivering an additional blow to household financial-market wealth. Already last year, households experienced an estimated $15 trillion decline in wealth as a result of a 20% decline in equity prices, a more than 10% decline in bond prices and a more than 60% decline in cryptocurrency prices. And the Dallas Federal Reserve is warning that US housing prices could drop by as much as 20% next year in response to this year’s doubling in mortgage rates.

If declining equity prices are not good for the economy, trouble in the credit markets could be very much worse for the economic outlook. This is especially the case when the world is drowning in debt and all too many loans have been made to creditors of poor quality at very low interest rates that do not reflect the risk of default.

World debt, per the International Monetary Fund, stands at some 250% of GDP, 20% higher than in 2008. And the Bank for International Settlements warned in a recent report that the world had some $80 trillion in additional “hidden debt” in the form of foreign-exchange swaps.

A combination of higher interest rates, an economic recession and a Fed that’s now reducing the size of its balance sheet has to raise the prospect of a wave of debt defaults next year at home and abroad. In particular, both highly leveraged US companies and the emerging market economies will have increased difficulty in rolling over the large amount of debt coming due next year when interest rates are high and the economy is in recession.

Before taking comfort in the fact that US banks are better capitalized today than they were in 2008 to deal with a credit-market crisis, the Fed might want to recall that the major part of credit has been extended by the non-bank segment of the financial system that includes the hedge funds and the equity funds. Being highly leveraged and largely unregulated, these non-bank financial institutions have the potential to cause the same kind of financial-market strains as Long-Term Capital Management did in 1998, when the highly leveraged hedge fund collapsed and the feds oversaw a bailout.

All this suggests the Fed should not be as cavalier as it seems to be about the risk that its monetary-policy hawkishness might invite a meltdown in the equity, housing and credit markets. Instead, it should be humble and nimble in its approach and stand ready to pivot away from monetary-policy tightening at the first sign of strains in the financial markets.

American Enterprise Institute senior fellow Desmond Lachman 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.

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