The Federal Reserve Is Steering the Economy toward a Hard Economic Landing

A nyone who still thinks that the Federal Reserve can guide us to a soft economic landing has not been paying attention. Between the Fed’s forecasting that a credit crunch (in which the banks make it more difficult for households and companies to borrow money) is coming and the seemingly irreconcilable differences between President Biden and Speaker McCarthy on the debt-ceiling issue, Treasury Secretary Janet Yellen’s dire warning of an impending economic catastrophe should be taken seriously.

Over the past year, the Fed has not only raised interest rates by 5 percentage points — the fastest pace in 40 years — but has also allowed the broad money supply to contract at a disturbing rate. A further tightening of monetary conditions at this delicate juncture could tip the economy into recession. The Fed’s recently released Financial Stability Report and Loan Officers Opinion Survey don’t lend readers much confidence.

At a time of economic weakness, the last thing that the U.S. economy needs is a credit crunch. Indeed, despite its claims of success, the Fed’s latest Financial Stability Report recognized that “decisive actions” by regulators and officials to tackle the recent regional-bank crisis have failed. Now, the report said, worries about the “economic outlook, credit quality, and funding liquidity” could lead “banks and other financial institutions to further contract the supply of credit to the economy.” That could spell disaster for the economy. As the report noted: “A sharp contraction in the availability of credit would drive up the cost of funding for businesses and households, potentially resulting in a slowdown in economic activity.”

Adding to the credit-market gloom, the Fed’s Senior Loan Officer Opinion Survey reported that already almost half of U.S. banks had been tightening their lending conditions. Further, it found that the banks expected to continue tightening lending standards for the rest of the year. This is hardly surprising. In the wake of Silicon Valley Bank’s and First Republic Bank’s failures, regional banks have been withdrawing deposits. To make matters worse, we are at the start of a real commercial-property-market crisis as a result of more people working from home in a post-Covid world. This is particularly problematic for the regional banks that have as much as 28 percent of their overall lending to the real-commercial-property sector.

Worse still — as if the Fed’s monetary-policy overkill was not enough to cause a recession on its own — we now seem to be headed for a self-induced debt-ceiling crisis. Yellen is warning that the debt ceiling could be exceeded by as early as the beginning of June and that all hell would break loose if the U.S. government defaulted on its debt. Meanwhile, House Speaker Kevin McCarthy and President Biden remain miles apart on resolving this issue.

McCarthy clings to his position that the Republican Party will not support a debt-ceiling increase without a commitment to deep public-spending cuts. This despite the fact that he knows full well that making such cuts — especially to the president’s student-loan program and designated additional funding for the IRS — is anathema to the Democratic Party. For his part, Biden insists that the ceiling should be raised with no strings attached to accommodate the spending increases that Congress already approved, as has been done on numerous previous occasions. If the past is any guide, it will take a financial-market crisis to get both sides to budge from their current hard-line negotiating positions.

All of this makes the Fed’s recent 25-basis-point interest-rate increase all the more difficult to understand. With the country on the cusp of a credit crunch and debt-ceiling crisis that could cause a painful recession, the last thing that the Fed should be doing is further tightening monetary policy. By making yet another major policy mistake, the Powell Fed is giving history every reason to judge it harshly.