Markets give thumbs down to the Fed

If ever there was a time for the Fed to be humble and nimble, it must be now.

It did not take markets long to give the Federal Reserve’s shift to a more hawkish monetary policy stance a resounding thumbs down. This must be of serious concern. Not because the markets are the economy, as Donald Trump would want us to believe. Rather it is because the markets’ pessimism could be self-fulfilling in the sense that it could help bring on the economic recession it fears.

Last Wednesday, at the conclusion of its monetary policy meeting, the Fed out-hawked the hawks. Not only did it raise interest rates for the third time by an unusually large 75 basis points, something that it has not done in 30 years. It also hinted strongly that there would be two further large interest rate hikes before the year was through.

In his post- meeting press conference, Fed Chair Jerome Powell took pains to leave no doubt that the Fed was determined to regain control over inflation and would not stop raising interest rates until it saw very clear signs that inflation was abating.

Markets both at home and abroad swooned in response to the Fed’s aggressiveness fearing that the Fed was engaging in monetary policy overkill. At home, all three major stock market indices slumped towards or beyond their June lows while bond yields, even on U.S. Treasuries, rose to decade-long highs. At the same time, abroad there was a major sell off in equities while the dollar surged to a 20-year high as investors rushed to the relative safety of the U.S. dollar.

One reason to think that the markets’ very negative reaction to the Fed’s move could push the economy into recession is that it entails a massive loss in household financial market wealth. Indeed, the approximate 25 percent decline in equity prices and 20 percent decline in bond prices since the start of the year represent a loss in household wealth of around $15 trillion, or close to 70 percent of GDP. A dent in their 401(K)s is the last thing that consumers struggling with high inflation need at a time when their confidence in the economy is already very low.

Another reason for fear is that higher interest rates on risky loans could push over-leveraged companies into bankruptcy, while higher mortgage rates could exacerbate the recessionary conditions already in evidence in the U.S. housing market. Even before mortgage rates jumped to their present 6.25 percent, from less than 3 percent at the start of the year, mortgage applications were down by 30 percent, housing affordability was at an all-time low and home builder confidence was very depressed. The most recent spike in interest rates is only going to exacerbate a bad situation.

It would be an understatement to say that a surging dollar and high interest rates will complicate an already very troubled world economy. This combination will be particularly challenging for the European economy, which is also suffering from decade-high inflation and is on the cusp of a meaningful recession this winter due to a Russian natural gas export shutdown. A weaker European economy and a weaker European currency in turn could have a serious impact on the earnings outlook of multinational U.S. companies dependent on foreign earnings.

High interest rates and a strong dollar are also not good news for the highly indebted emerging market economies in the sense that they are likely to exacerbate the repatriation of capital to the United States that is already well underway. Should that repatriation trigger the wave of emerging market debt defaults about which the World Bank keeps warning, we could have added stress on our financial system.

All of this puts the Federal Reserve in a very difficult position. Backing down so soon after its last Federal Open Market Committee meeting on its shift to a more hawkish monetary policy stance could raise questions about its inflation fighting credibility. Yet sticking to its hawkish line could be highly unsettling for the financial markets, which could invite a hard economic landing both at home and abroad. If ever there was a time for the Fed to be humble and nimble, it must be now.

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.