‘Be careful what you wish for’ as Fed steps up aggression on monetary policy

U.S. Federal Reserve Chair Jerome Powell speaks during a news conference in Washington, D.C., May 4, 2022.

Jim Watson | AFP | Getty Images

We’ve come to the “be careful what you wish for” moment for Federal Reserve policy.

After months of scathing criticism from former Treasury officials, Wall Street economists and others for presumably falling behind the inflation curve, the Fed is now facing mounting complaints — from these same people — that its more aggressive inflation-fighting plans will boost the economy. US economy. in recession.

With housing activity falling sharply in the US, second-quarter gross domestic product estimates being revised downwards and a rapid build-up of business inventories, it is clear that the economy is slowing much more noticeably than so-called experts anticipated. This is starting to cause the kind of market-related stress that, in the past, put an end to Fed tightening cycles.

Consumers are pulling their horns

Mortgage applications plummeted. Mortgage refinancing activity is dead in the water. Pending home sales, as well as new and existing home sales, have dropped in recent months.

With a 30-year fixed rate mortgage now at about 6%, a $450,000 home purchased with a 3% mortgage last year has about the same monthly payment as a $320,000 home purchased at today’s rate. . Talk about sticker shock!

Consumers seem to be pulling their horns. They used excess savings accumulated during the pandemic, resorting to credit card purchases instead of cash.

To some, this indicates that the supposed $2.5 trillion in surplus savings has evaporated.

Indeed, after peaking at nearly 34% in the depths of the pandemic – owing to generous measures to mitigate the economic impact of sheltering in place and working from home – the personal savings rate has dropped to 4.4%, roughly where was before. -pandemic.

Of course, there was also the obvious impact on financial markets.

The Nasdaq Composite is down more than 30% from its all-time high. The S&P 500 is more than 20% below its all-time high. Think about the negative wealth effect here.

Speculative meme stocks have plummeted. Highly prized technology has fallen. US Treasuries had the worst six-month performance in bond market history. Credit spreads widened and cryptocurrencies fell.

The spread between high-yield debt and comparable Treasuries has exploded, increasing the risk of default among borrowers that are below investment grade.

Ford says auto loan defaults are on the rise, while 60% of company CEOs predict a recession is now likely in the next 12 to 18 months.

It looks like it won’t be that long, judging by the current market-based recession indicators.

Indeed, there will be economic pain from a more aggressive move by the Fed to curb inflation, which stems more from supply-side disruptions than demand-side imbalances.

Overseas Policies

The Fed’s policy, which essentially influences interest rate policies around the world, is also causing tensions outside our borders.

The European Central Bank held an emergency meeting to find ways to support Europe’s most indebted countries – including Italy, Spain and Portugal – even as it raises rates to fight inflation.

Good luck with executing these policies concurrently.

Global monetary policies are asynchronous: China and Japan are easing, while the US, EU, Britain and Switzerland are tightening.

This could lead to additional global tensions, as the unintended consequences of “zero coordination policies” will push some markets to the breaking point.

We witnessed this in 1994, during the Mexican peso crisis, in which there were huge tensions in the peso-dollar parity. This prompted the US Treasury and the International Monetary Fund to bail out Mexico when its currency plummeted.

Orange County, California, thanks to some horrible bond bets on its own treasury, declared bankruptcy in 1994. This prompted the Fed to change course and begin cutting interest rates to stop the damage done at home and abroad. .

Likewise, the Asian currency crisis in 1997, the Russian debt crisis and the related collapse of Long-Term Capital Management also forced the Fed to stop raising rates and start easing again.

It is often said that the Fed will raise rates “until something breaks”.

Something is about to break somewhere. With the benefit of hindsight, those who asked the Fed to be aggressive will also claim that they foresaw the consequences of a tough tightening cycle.

I hope someone calls them to such duplicity.

— Ron Insana is a contributor to CNBC and a senior consultant for Schroders.

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