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Desmond Lachman: On our way to a hard economic landing

Anyone who believes that the Federal Reserve will succeed in its efforts to reduce inflation without causing a hard economic landing has not been paying attention to the recent meltdown in the financial markets. Nor have they been paying attention to the dramatic increase in mortgage rates or to the rapid rise in the dollar.

Until very recently, both the stock market and the bond market boomed as seldom before on the back of ultra-low interest rates and the Fed's $120 billion a month liquidity injection into the markets through its bond-buying activities. By the end of last year, equity valuations had reached nosebleed levels experienced only once before in the past 100 years while interest rates on risky loans were at close to historic lows.

Fast forward to this year and we have a completely different story. As the Fed has been forced to shift to a hawkish monetary policy stance to bring down multi-decade high inflation, which the Fed itself had created, the bottom has fallen out of the equity, bond and crypto currency markets.

It has done so as markets are coming to terms with the Fed's announcement that it will now increase interest rates in 50 basis point steps rather than the more normal 25 basis point steps and that, beginning in August, it will start draining as much as $95 billion a month in liquidity from the markets by not rolling over its maturing bond holdings.

Markets are also having to get used to the idea that they can no longer expect that the Fed will ride quickly to their rescue, as they have done in the past when the going got tough. Indeed, the Fed is talking as if it welcomes some decline in the stock market.

Since the start of this year, both the stock market and the bond market have lost almost 20 percent of their value while exotic markets such as Bitcoin have lost 50 percent of their value. This means that since the start of the year some $12 trillion, or 50 percent of GDP, in household wealth has evaporated. It's only a matter of time before we see a deep slump in consumer demand as households try to rebuild their savings.

If the Fed's calculations are correct that for every $1 loss in wealth, households cut back on spending by 4 cents, we could see consumer spending decline by as much as 2 percent of GDP because of the recent loss in wealth. This is the last thing the economy needs at a time when households are finding that inflation is outpacing their wage gains and that they are having to pay around $4.50 a gallon for their gasoline.

Further clouding the prospect for a soft economic landing is the recent dramatic run up in mortgage rates. Since the beginning of the year, the 30-year mortgage rate has spiked from around 3 percent to its present level of 5.5 percent in parallel with the doubling in the 10-year Treasury bond rate. This has reduced housing affordability by some 25 percent. That in turn heightens the chances that a slump in housing demand will once again play a key role in leading the economy into recession.

It is also hardly helping matters that the dollar is surging while our key trade partners are experiencing sharp economic slowdowns. The dollar has now risen to its strongest level in the past 20 years as foreign investors have been attracted by higher U.S. interest rates and have sought the safety of U.S. Treasuries at a time of world financial market uncertainty. This is having the effect of reducing our export competitiveness and of cheapening our imports, thereby increasing our trade deficit.

All of this raises questions as to whether the Fed is now being overly aggressive in fighting inflation especially at a time that last year's large Biden budget stimulus is fading. If our economy succumbs to a deep economic recession, inflation will become the least of our economic problems.

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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Posted: May 20, 2022 Friday 09:30 AM