A mistake-prone Federal Reserve
With its policy credibility in tatters following the recent surge in inflation to a 40-year high, the Federal Reserve can ill-afford to make another major policy mistake.
Yet that is what it seemed to have done at its most recent policy meeting. By committing itself to an overly aggressive monetary policy to get the inflation genie back into the bottle, the Fed has heightened the odds that we are now in for a harder than usual economic landing.
It would be a gross understatement to say that the Fed, led by chair Jerome Powell, made major policy mistakes last year. At a time when the economy was growing strongly and receiving its largest peacetime budget stimulus on record, the Fed chose to keep its pedal to the monetary policy metal. It did so by keeping its policy rate at its zero-lower bound despite rising inflation. That made those rates significantly negative in inflation-adjusted terms. It also did so by allowing the money supply to balloon by around 40 percent over the past two years or by its fastest pace in over 50 years.
Similarly, last year at a time when the equity, housing and credit markets were on fire, the Fed chose to keep fueling those markets with additional massive doses of liquidity. It did so by buying $120 billion a month in Treasury bonds and mortgage-backed securities.
It should have been little wonder then that consumer price inflation surged to 8.5 percent with such an extraordinarily easy monetary policy stance. Nor should it have come as a surprise with so much liquidity sloshing about that by the end of last year we had bubble-like conditions in the housing, equity and credit markets as well as a debt party in the emerging market economies.
Having made the policy mistake last year of keeping its foot too firmly on the accelerator for too long when the economy was recovering strongly, the Powell Fed now seems to be making the opposite policy mistake. It is slamming on the monetary policy brakes too hard to control inflation at the very time that the equity and bond markets are already swooning.
The Fed’s mistake is not so much that it is committing itself to a series of 50 basis point interest rate hikes over the next few policy meetings. Rather, it is that it is committing itself to a path involving the reduction in its balance sheet by $95 billion a month through not rolling over its bond holdings at maturity.
The Fed has now put itself on a path that will involve a staggering $215 billion a month swing in liquidity provision. Instead of providing the market with $120 billion a month in liquidity, as it did last year, the Fed soon will be draining $95 billion a month by not rolling over its large bond holdings at maturity.
In putting itself on this path, the Powell Fed does not seem to have asked itself a few basic questions. If providing $120 billion a month in liquidity last year created bubble-like conditions in the equity, housing and credit markets, why will withdrawing $95 billion a month not cause those bubble-like conditions to give way to a prolonged slump? If flooding the markets with liquidity last year allowed the emerging market economies to become over indebted, why will withdrawing liquidity on a massive scale not bring in its wake the wave of emerging market defaults about which the World Bank has been warning?
The Powell Fed is no stranger to major policy blunders. In early 2021, just as inflation was beginning to pick up steam, the Fed made a major change in its policy framework by shifting to a flexible average inflation targeting regime that would tolerate a period of higher inflation. Today, just at a time when the equity and bond markets are swooning and emerging market currencies are slumping, the Fed is committing itself to a prolonged period of liquidity destruction.
This does not bode well for the Fed’s chances of securing a soft economic landing. Nor does it look good for the Fed’s chances of restoring its battered policy credibility when it will soon be forced to make another major policy U-turn.
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.
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