At this week’s policy meeting, the Federal Reserve will have to choose its poison. If it fails to accelerate the pace of interest-rate hikes, it risks losing control over runaway inflation. Yet if it surprises us with a faster pace of interest-rate increases, it risks further tanking the stock market, thereby creating the conditions for an early hard economic landing.
The Fed is largely to blame for its terrible policy dilemma. Last year, when the country’s largest peacetime budget stimulus on record risked overheating the economy, the Fed kept interest rates at their zero lower bound and allowed the money supply to balloon. It did so in the mistaken belief that the pickup in inflation was but a transitory phenomenon caused by COVID-induced supply-chain disruptions.
At the same time, the Fed kept injecting $120 billion a month in liquidity into the markets through its bond-buying activities — despite the fact that the stock market was booming and the housing market was on fire.
The net result of the Fed’s monetary-policy largesse has been both sky-high inflation and asset-price and credit-market bubbles. Even before Russia’s Ukrainian invasion sent oil and food prices through the roof, inflation had spiked to levels last seen in the early 1980s. Similarly, by the end of last year, equity valuations reached nosebleed levels recorded only once before in the last 100 years, while housing prices exceeded their 2006 peak even in inflation-adjusted terms.
With inflation having become the nation’s No. 1 economic problem and running at some four times the Fed’s 2% inflation target, the bank had little alternative but to make an abrupt tactical U-turn. At is last policy meeting, in April, it indicated that it would start raising interest rates in 50 basis-point steps, rather than the more normal 25 points. It also announced that starting in the fall, it would be withdrawing as much as $95 billion a month in liquidity from the market by not rolling over its maturing bond holdings.
It would be an understatement to say that the stock market has not taken kindly to higher interest rates and the notion that the Fed will no longer have its back by flooding the market with liquidity. Since the start of the year, the S&P 500 has lost more than 20% in value while the tech-heavy NASDAQ has lost more than 30%. This represents the evaporation of around $9 trillion, or more than 40% of GDP, in household wealth.
When the Fed meets Tuesday and Wednesday, it will be not only against the background of a tanking stock market. It will also have to grapple with plummeting consumer confidence because of high inflation, a crumbling housing market and the risk that an already uncomfortably high inflation rate could be pushed higher by rising oil prices and more Chinese supply-side disruptions as a result of that country’s zero-tolerance COVID policy.
All this leaves the Fed with the most unenviable of policy choices. It can now begin raising interest rates in 75 basis-point steps, even at the risk of further unhinging the stock market and bringing on a recession by year’s end. Alternatively, it can stick to its current path of 50 basis-point increases even though that risks allowing inflation expectations to become entrenched and setting us up for an even harder economic landing next year.
On the basis of the Powell Fed’s record of policy timidity, my money is on the Fed sticking to its current 50-point-increase path. However, I am hoping that it surprises us by doing the right thing and tackling the inflation beast by the horns now with a 75 basis-point hike.
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.