The Powell Fed has lacked patience in its monetary-policy management, and we are now paying a heavy economic price.
The Powell Fed has lacked patience in its monetary-policy management, and we are now paying a heavy economic price.
W hen it comes to today’s monetary policy, Jerome Powell’s Federal Reserve is behaving like an impatient person using a thermostat. First, when the room is too cold, the person sets the thermostat to very hot. Then, when the room gets too hot, the person abruptly swings the thermostat to very cold. The net result is that the room is seldom at the right temperature for very long.
In early 2020, in response to the Covid-induced recession, the Powell Fed stomped on the accelerator to promote economic recovery. It quickly cut policy interest rates to their zero-bound and engaged in a round of Treasury bond and mortgage-backed-security buying at a speed that had no precedent. When responding to the 2008–2009 Great Economic Recession, it took the Bernanke Fed six years to increase the Fed’s balance sheet by around $4 trillion through its bond-buying activities. It took the Powell Fed less than nine months to do something similar in 2020.
Last year, the inexcusable mistake that the Powell Fed made was to keep its pedal fully to the monetary-policy metal for far too long. It did so even though the economy was recovering strongly, inflation was picking up, and the economy was receiving its largest peacetime budget stimulus on record. It also did so despite the fact that the U.S. equity and housing markets were going through the roof.
Seemingly oblivious to the economy’s changed circumstances, and seemingly forgetting that monetary policy operates with long and variable lags, the Fed kept interest rates unchanged at their zero-lower bound. Until the year’s end, it also continued to buy $120 billion in Treasury bonds and mortgage-backed securities. This bond-buying contributed to a 40 percent increase in the broad money supply over the past two years.
The net upshot of the Fed’s 2021 monetary-policy largesse is that we now have both an inflation and an asset-price inflation problem. At 8.3 percent, consumer-price inflation is now running at its highest rate in the past 40 years. At the same time, by the end of last year, equity valuations had reached nosebleed levels experienced only once before in the past 100 years, while house prices have exceeded those from the eve of the 2006 housing-market bust — even in inflation-adjusted terms.
To deal with the inflation problem, the Fed is now slamming on the monetary brakes hard. It is doing so by raising interest rates in 50 basis point rather than the more-normal 25 basis-point steps. It is also proposing that, beginning in August, it will withdraw $95 billion a month in liquidity from the markets by not rolling over its maturing bond holdings.
Just as keeping its foot on the accelerator for too long led to economic overheating by end-2021, so too there is now the real risk that slamming on the monetary policy brakes too hard will provoke a deep economic recession. Just as when the Fed created asset-price bubbles by adding $120 billion a month in liquidity to the markets, so too, when it withdraws $95 billion a month in liquidity, it risks causing that asset-price bubbles to burst.
Among the reasons for fearing a deeper-than-normal recession is that today’s monetary-policy tightening is already causing the equity- and credit-market bubbles to burst. Since the start of the year, the Fed’s abrupt policy shift has wiped out almost 20 percent of the stock market’s value. It has also wiped out nearly 20 percent in the bond market’s value and close to 50 percent in the value of exotic markets such as Bitcoin.
The combined evaporation of some $12 trillion, or 50 percent of GDP, in household wealth since the start of the year, must be expected to cool consumer demand. It will do so as households feel less wealthy than before, which will make them want to rebuild their savings.
Another cause for concern about a prospective deep recession is that the Fed’s monetary-policy tightening has led to an abrupt jump in the 30-year mortgage rate from around 3 percent at the start of the year to 5.5 percent at present. This has reduced the affordability of housing by 25 percent. That in turn is already leading to a marked cooling in housing demand.
The moral of the story is that, just as we need patience and a steady hand when trying to moderate a room’s temperature, so, too, do we need patience and a steady hand at the Federal Reserve to reorient the economy. Unfortunately, the Powell Fed has lacked both patience and steadiness in its monetary-policy management, and we are now paying a heavy economic price.