The Federal Reserve Could Tank the U.S. Economy

October 31, 2023 Topic: Federal Reserve Blog Brand: Politics Tags: Federal ReserveU.S. EconomyEconomyPolitics

The Federal Reserve Could Tank the U.S. Economy

If the Fed does not soon change policy course, we should brace for a very hard economic landing next year.

John Maynard Keynes famously said that “when the facts change, I change my mind. What do you do sir?”.

Since the Federal Reserve’s last policy meeting in September, the facts have changed for the worse in a major way for the US economy. The question now is whether the new facts will change the Fed’s mind and induce it to back off its “high interest rates for longer” mantra.

One way in which the facts have changed has been the spike in long-term interest rates in the wake of the return of the bond market vigilantes. Concerned about how the government will finance its ballooning budget deficit, which is running at 8 percent of GDP at a time of cyclical strength, the markets have dumped government bonds in a big way. That has driven up the bell weather 10-year Treasury bond yield to close to 5 percent or to its highest level in 16 years. That, in turn, has caused a rise in mortgage and auto loan rates to a demand crimping 8 percent.

A number of Fed officials seem to recognize that from the point of reducing aggregate demand, the recent spike in long-term Treasury bond yields is equivalent to several Fed interest rate hikes. This is especially the case considering that long-term Treasury bond yields are the key determinant for housing and automobile loan rates. As those rates rise beyond a certain threshold, one must expect that housing and automobile demand will be crushed.

Not recognized by Fed officials, at least in public, is the serious damage that the recent long-term interest rate spike is doing to the banking system’s balance sheet. It is doing so by reducing the value of its bond portfolio. Even before the recent spike, it was estimated that the banks had mark-to-market losses on their bond portfolios of some $620 billion. The recent bond yield spike could add a few more hundred billion dollars to those losses.

The impairment to the banks’ balance sheets is occurring at a time when the banks are facing the prospect of a wave of loan defaults in general and of commercial property loan defaults in particular. It is difficult to see how property companies are going to roll over the $500 billion in property loans falling due next year at markedly higher interest rates than those at which the loans were initially contracted at a time when they are experiencing meager occupancy rates in a post Covid-world.

All of this has heightened the prospect that soon we will have another round of the regional bank crisis that started at Silicon Valley Bank earlier this year. It must only be a matter of time before markets question the regional banks’ solvency, as indicated by the recent swoon in regional bank share prices. Not only do those banks have large bond portfolios. They also have as much as 18 percent of their balance sheets exposed, and they are now also having to pay much higher interest rates to maintain their deposit bases.

Another way in which the economic facts have changed for the worse has been the start of what is widely expected to be a long war between Israel and Hamas. According to the World Bank, if that war spread to the rest of the region, we could see international oil prices spike to $150 a barrel. The prospect of such a supply shock is bound to impact both investor and household expectations adversely.

In March 2021, when the Biden Administration secured passage of the budget-busting American Rescue Plan, the Federal Reserve did not change its policy of unprecedented monetary policy ease. The net upshot was a surge of inflation to a multi-decade high. We have to hope that the Fed has learned from that past egregious policy mistake. Maybe then it will back off from its newfound monetary policy religion in light of new facts that point to heightened economic and financial market risks.

If the Fed does not soon change policy course, we should brace for a very hard economic landing next year.

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.