[This article has been published in Restoring America to consider how the Federal Reserve’s policies might be driving the U.S. economy toward a recession.]
The Federal Reserve has hardly covered itself in glory by having failed to anticipate recent major turning points in the U.S. 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, U.S. 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% and 20% in value, respectively, the bond market, too, has lost around 20% while the cryptocurrency markets have lost some 70%.
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% 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% at the start of the year to close to 6% 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 U.S. 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.
This article originally appeared in the AEIdeas blog and is reprinted with kind permission from the American Enterprise Institute.
