With recession looming, the Fed may be doing more harm than good

Hope springs eternal at the Federal Reserve. At a time when all clues point to a recession before year’s end, the Fed clings to the belief that it can slay the inflation dragon while securing a soft economic landing.

This does not bode well for the economic outlook. It likely means that much in the same way as last year the Fed kept monetary policy too loose for too long thereby producing multi-decade high inflation, it will now keep monetary policy too tight for too long. That risks producing an even deeper economic recession to bring inflation back under control.

While Fed Chairman Jerome Powell keeps assuring us that we can avoid a recession, the Atlanta Federal Reserve seems to have a different view. According to its GDP Now economy tracker, which has been a reliable leading economic indicator, the economy contracted by around 1 percent in the second quarter. If that turns out to be the case, we will have had two quarters of negative growth, which is the popular definition of a recession.

Leaving aside how the economy might have done in the last quarter, many indicators suggest that the economy is in for a very rough second half of the year.

The equity market has just closed out its worst first half-year performance since 1970. Together with parallel large declines in the bond and crypto currency markets, since the start of the year around $15 trillion, or 70 percent of GDP, in financial wealth has evaporated. Coupled with multi-decade high inflation, this huge loss in wealth is bound to cause a slump in consumer spending. This is already suggested by a drop in consumer confidence to its lowest level on record.

Another indication of real trouble ahead is the largest increase in long-term mortgage rates in the past 30 years. Since the start of the year, the 30-year mortgage rate has almost doubled from around 3 percent to its present level of 5.5 percent. That has implied a more than 25 percent slump in housing affordability. This must make it only a matter of time before the housing market crumbles.

What’s more, the traded goods sector could inhibit economic growth. The dollar has surged to a 20-year high, and our economic partners are slowing down, which means  we can expect our exports to slump and our imports to boom.

As if all of this were not enough cause for concern, we also have a very different macroeconomic policy setting than we had before. Last year, both budget and monetary policy were highly supportive of economic growth. This year the picture is very different. The March 2021 American Rescue Plan has long since run its course. Meanwhile, the Fed’s zero interest rates and massive bond-buying have given way to 75 basis point interest rate increases and the start of substantial Fed bond selling.

Last year, the Fed kept policy too loose for too long despite the many indications of a strong inflationary surge. This year it seems to be making the same mistake but in reverse. It is putting itself on a substantial monetary policy tightening path at the very time that there are many indications of real trouble ahead.

In the past, Fed Chair Powell has indicated that the Fed should be both humble and nimble. One must hope that he heeds his own advice. If so, he might soon have the Fed do a monetary policy U-turn that might spare us a very hard economic landing.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly 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.