In his Jackson Hole speech last week, Federal Reserve Chair Jerome Powell enumerated a number of lessons that are now guiding his thinking as to the appropriate stance of monetary policy. Notable in his speech, however, was his failure to mention several even more relevant lessons in today’s economic setting. That omission is likely to keep the Fed on an overly hawkish monetary policy action course that will produce an unnecessarily hard economic landing.
It is difficult to take exception to Powell’s assertion that the Fed can and should take responsibility for delivering low and stable inflation. Nor can one argue with his view that public expectations about inflation play an important role in setting the path of inflation over time and that the Fed should keep at it until the job is done.
But one can bemoan that Powell continues to ignore probably the most important lesson from past monetary policy experience on which almost all economist can agree. It is that monetary policy operates with long and variable lags.
In 2021, the Fed’s failure to remember that lesson contributed to a surge of inflation. It did so by inducing the Fed to keep interest rates too low for too long even as inflation was rising and the economy was receiving its largest peacetime budget stimulus on record. Now, after already having tightened monetary policy substantially since the start of the year, the Fed risks producing a hard economic landing by failing to recognize the long lags with which monetary policy operates.
The Fed does so by contemplating further large interest rate increases even at a time when there are clear signals that inflation has already peaked and that the economy is already slowing. Not only has the economy already recorded two consecutive quarters of negative economic growth. Consumer sentiment is slumping, and the housing market is already in a meaningful recession as a result of the rise in mortgage rates from below 3 percent at the start of the year to around 5.5 percent at present.
Another important lesson that the Fed seems to be ignoring is that market liquidity is a fundamental determinant of stock market and housing market prices. Last year, by adding $120 billion a month in market liquidity through its purchases of Treasury bonds and mortgage-backed securities, the Fed contributed to bubble-like conditions in both the stock market and the housing market.
Now the Fed risks causing those bubbles to burst in a way that could damage the economy. It is doing so by withdrawing $95 billion a month in liquidity by choosing not to roll over its bond holdings at maturity at the very time when financial markets are already on the back foot.
Yet another lesson to which the Fed is seeming to turn a blind eye is that its interest rate decisions have an important bearing on the rest of the world economy, whose performance can have important spillover effects to the U.S. economy and its financial markets.
The Fed’s interest rate hikes to date have already caused capital to be repatriated at an increasing pace from the heavily indebted emerging market economies. That is now prompting the World Bank to warn about the risk of another emerging market debt crisis.
At the same time, the Fed’s interest rate hikes have caused a substantial strengthening of the dollar. That is the last thing that the European economy needs as it struggles with strong inflationary pressures from rising energy prices in the wake of Russia’s war with Ukraine.
All of this raises serious questions about the advisability of the Fed’s current hawkish monetary policy stance, which involves interest rate hikes in 75 basis-point increments and balance sheet reduction at a pace of $95 billion a month. Rather, the Fed would be better advised to raise interest rates and shrink its balance sheet’s size by less aggressive amounts.
That would give it time to see how its monetary policy tightening will impact both the domestic and the world economies over the longer run.
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.