So much for the soft economic landing. 

The disappointing consumer price inflation numbers released on April 10 suggest that inflation will not come down to the Federal Reserve’s 2 percent target without a recession. The numbers also suggest that interest rates will need to stay high for longer in order to regain control over inflation. That could spell real trouble for the financial system in general and regional banks in particular. It could also make the economy a central focus of the November presidential election.

Over the past year, core consumer prices, which exclude food and energy prices, are estimated to have risen by 3.8 percent—close to double the Fed’s target. This leaves the Fed with little option but to maintain its hawkish monetary policy stance.

In recent public statements, Federal Reserve Chairman Jerome Powell has reiterated that the Fed will only cut interest rates when it sees clear signs that inflation is coming down on a sustainable basis toward the Fed’s target. Today’s inflation numbers, along with jobs numbers that remain strong, make interest rate cuts before the second half of the year highly improbable. This is especially the case given the deteriorating situation in the Middle East, which is once again driving up international oil prices.

To say that the Fed’s earlier ultra-easy monetary policy has put it into a box would be an understatement. That policy not only caused multi-decade inflation, it also helped fuel a commercial real estate problem and a frothy equity market.

The Fed’s fundamental policy predicament is that it has only one interest rate, but it needs two different interest rates—one for its inflation problem and one for its financial system problem. High interest rates are needed for longer periods to control inflation. At the same time, it needs low interest rates, and soon, to ease strains on the financial system that are now strengthening as a result of the slow-motion train wreck hitting commercial property. 

In the months ahead, the Fed will have to choose. It can seek to attain its inflation target and give up on financial stability. Or, it can ensure financial stability with low interest rates while accepting a higher inflation rate than it hoped to achieve.

Up until now, the Fed has been able to largely disregard the problems afflicting the commercial property sector. Banks have engaged in a policy of “extend and pretend” with their commercial property lending: They have extended troubled loans by pretending that these loans were still performing well.

However, it is becoming increasingly difficult for banks to continue pretending that their commercial loan portfolios are performing. Unusually high vacancy rates as a result of the increased tendency of people to work from home are now expected to cause commercial property prices to fall by at least 40 percent from their 2022 peaks. Meanwhile, high interest rates are going to make it extremely difficult for property developers to roll over the $930 billion in property loans maturing this year. This could cause a wave of commercial property loan defaults.

In September 2008, on the eve of that year’s election, the Lehman bankruptcy produced a serious financial crisis. With today’s inflation numbers, there is a risk of another financial crisis in the run-up to the November elections, albeit one with a far lesser degree of severity. Such a crisis could center on regional banks, which have unusually large exposure to commercial property lending and whose large bond portfolios are causing them massive mark-to-market losses. This could have real spillover effects on the rest of the economy and make its health the main focus of the elections.

About the Author: Desmond Lachman 

American Enterprise Institute senior fellow Desmond Lachman was 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.

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