Markets give thumbs down to the Fed

It didn’t take long for markets to take a positive view of the Federal Reserve’s move to a tighter monetary stance. This must be a cause for serious concern. Not because the markets are the economy, as Donald Trump would have us believe. Rather, it is because the markets’ pessimism could be self-fulfilling in the sense that it could help bring about the feared economic recession.

Last Wednesday, at the close of its monetary policy meeting, the Fed outperformed the hawks. Not only has it raised rates by an unusually high 75 basis points for the third time, something it hasn’t done in 30 years. It also strongly suggested that there would be two more big rate hikes before the end of the year.

In his post-meeting press conference, Fed Chair Jerome Powell left no doubt that the Fed was determined to regain control of inflation and would not stop raising rates until it saw very clear signs that the inflation subsided.

Markets both at home and abroad swooned in response to the Fed’s aggressiveness, which feared the Fed was engaging in monetary policy overkill. Domestically, all three major stock market indices fell at or above their June lows, while bond yields, even on US Treasuries, rose to decades highs. At the same time, there was a major sell-off in equities overseas as the dollar soared to a 20-year high as investors rushed to the relative safety of the US dollar.

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One reason to believe that the very negative market reaction to the Fed’s move could push the economy into recession is that it will result in a massive loss of household financial market wealth. In fact, the roughly 25 percent decline in stock prices and 20 percent decline in bond prices since the start of the year translates into household wealth losses of around $15 trillion, or nearly 70 percent of GDP. A dent in their 401(K)s is the last thing consumers struggling with high inflation need at a time when their confidence in the economy is already very low.

Another reason for concern is that higher interest rates on risky loans could bankrupt over-indebted companies, while higher mortgage rates could exacerbate the recessionary conditions already emerging in the US housing market. Even before mortgage rates rose to their current 6.25% from less than 3% earlier in the year, mortgage applications were down 30%, housing affordability was at an all-time low and homebuilder confidence was severely depressed. The recent rise in interest rates will only make a bad situation worse.

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It would be an understatement to say that a rising dollar and high interest rates will weigh on an already troubled global economy. This combination poses a particular challenge for the European economy, which is also suffering from decades of inflation and is on the cusp of a major recession this winter due to a Russian natural gas export ban. In turn, a weaker European economy and currency could have a serious impact on the earnings prospects of US multinationals that are dependent on foreign earnings.

High interest rates and a strong dollar are also bad news for the heavily indebted emerging markets, as they are likely to exacerbate the repatriation of funds to the United States, which is already in full swing. Should this repatriation trigger the wave of debt defaults in emerging markets that the World Bank has repeatedly warned about, we could have put additional strain on our financial system.

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All of this puts the Federal Reserve in a very difficult position. A backslide so soon after its last Federal Open Market Committee meeting on its switch to a more hawkish monetary policy stance could cast doubt on its credibility in the fight against inflation. However, sticking to its hawkish stance could be extremely unsettling for financial markets, which could result in a hard economic landing both domestically and internationally. If there was ever 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. Previously, he was Associate Director in the Department of Policy Development and Review at the International Monetary Fund and Senior Economic Strategist for Emerging Markets at Salomon Smith Barney.