The Fed must hit the brakes or risk an unnecessarily painful recession
John Maynard Keynes famously said, “When the facts change, I change my mind. What do you do, sir?” One has to hope Federal Reserve Chair Jerome Powell heeds Keynes’ advice when he addresses the Fed’s annual Jackson Hole meeting Friday.
Economic facts have changed for the worse over the past few months. A rapidly weakening world economy and clear signs of economic cooling at home should ease US inflationary pressure substantially. If the Fed persists with its aggressive interest-rate hikes in these circumstances, it risks sending the economy into an unnecessarily deep recession to reduce inflation.
In recent speeches, Powell has signaled the Fed intends to maintain a hawkish monetary-policy stance until it sees very clear signs that inflation is moderating towards its 2% targeted level. The bank has been increasing its policy interest rate in 75 basis-points steps rather than by the more normal 25 basis points and rapidly reducing the size of its balance sheet by not rolling over the maturing bonds it holds.
The Fed is maintaining this hawkish posture even though the economy has contracted in two successive quarters. And it’s doing so despite the marked slump in consumer confidence and growing signs that sharply higher mortgage rates are causing the housing market to crumble. The central bank justifies its moves on the argument that inflation remains uncomfortably high at around 8.5% and the labor market remains tight as evidenced by an unemployment rate close to a 50-year low.
Surprisingly, the Fed seems to be turning a blind eye to the strong deflationary forces emanating from abroad as a result of the rapidly deteriorating state of the world economy. That deterioration has already propelled the dollar sharply higher and caused international commodity prices, most notably oil, to fall by more than 20%. There’s every prospect that in the period immediately ahead these deflationary forces will gather strength.
Europe would seem to be among the global economy’s most troubled parts. Its economy was struggling even before Russian President Vladimir Putin threatened to cut Europe off from energy imports in his effort to divide the continent over its support for Ukraine. If Putin carries out his threat this winter, Europe could experience a deep economic recession.
Without Russian natural gas, the International Monetary Fund says, the German economy could be almost 5% below where it would otherwise have been. Little wonder then that the euro has declined to below parity against the dollar, its lowest level in 20 years.
Compounding the world’s economic woes is the fact that the chickens seem to be coming home to roost in China’s imbalanced economy. Far from growing at the government’s targeted 5.5% rate, the Chinese economy has screeched to a virtual halt. This is a result of the country’s zero-tolerance COVID policy as well as the bursting of its property-market bubble.
That more than a million Chinese families are boycotting making mortgage payments does not bode well for any early recovery in the country’s economy. Nor does the prospect of heightened tensions between China and the United States over Taiwan.
As if Europe’s and China’s economic agonies weren’t sufficient reason for concern, the highly indebted emerging-market economies appear to be on the cusp of a wave of defaults. Argentina, Russia, Sri Lanka, Ukraine and Venezuela have already defaulted, with Egypt, Pakistan and Turkey looking to be next in line. They’re in this unfortunate position in great measure due to the large outflow of money from these countries in response to higher US interest rates.
Our country’s inflation prospects must be expected to benefit from the economic troubles abroad and the cooling at home. Not only are international oil, metal and food prices likely to continue to fall; the return of international investor risk aversion will probably damage our financial markets at the same time that a likely strengthening dollar will cheapen our import costs and diminish our export prospects.
By continuing to aggressively raise interest rates at a moment of incipient domestic economic weakness and a brewing perfect economic storm abroad, the Fed is inviting a hard US economic landing. Let’s hope that Powell recognizes this risk and dials down the pace of interest-rate increases.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He 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.