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There is good reason to be disappointed with the Federal Reserve. It has gotten us into an awful economic mess as a result of its earlier ultra-easy monetary policy. That policy managed to create both an inflation and a financial stability problem.
But the Fed has only one interest rate policy to address those two problems. This means that the Fed will have to choose its poison. Either the Fed will have to keep interest rates high to meet its inflation target but give up on maintaining financial stability. Or else it can cut interest rates to stabilize the financial system but, in the process, jeopardize its inflation goal.
The Fed’s predicament stems from the fact that it kept monetary policy too loose for too long in response to the 2020 Covid-induced recession. Even after the economy was recovering and receiving its largest peacetime budget stimulus on record, it kept interest rates at their zero bound until as late as March 2022.
At the same time, it engaged in over $4 trillion in bond purchases, and it allowed the broad money supply to expand by a staggering 40 percent from the start of 2020 to the end of 2021.
The Fed’s monetary policy largesse helped send inflation to a multi-decade high of 9.1 percent by June 2022. At the same time, it helped fuel a commercial real estate bubble and a frothy equity market.
Fast forward to today, and the Fed has managed to bring inflation down to around three percent. It has done so by raising interest rates by five and a quarter percentage points, or by the most since the early 1980s.
It has also engaged in aggressive quantitative tightening and allowed the broad money supply to contract for the first time in over 70 years. However, even the Fed sees that it is too early to declare victory over inflation and recognizes that interest rates will have to be kept at their current high level at least until the second half of the year.
This would be especially the case if we were to have an oil price shock and supply chain interruptions on the heels of any widening of the Israel-Hamas war.
A major problem for the Fed is that a slow-motion train wreck is now underway in the commercial property sector. Not only are office vacancy rates going through the roof as a result of the increased tendency of workers to work from home, this year property developers are going to have to roll over $930 billion in maturing debt at considerably higher interest rates than those at which those loans were originally contracted.
It is difficult to see how we will not have a wave of commercial property defaults if the Fed sticks to its high interest rates for longer policy. Commercial property prices have already fallen by more than 20 percent and are widely expected to fall another 20 percent before they finally trough.
Early last year, we had a regional bank crisis centered on Silicon Valley Bank. If we now have a wave of commercial property loan defaults, we could have another major regional bank crisis that could have spillover effects to the rest of the financial system and tip the economy into recession.
A recent National Bureau of Economic Research paper underlines this point. It warns that close to 400 small and medium-sized banks could fail as a result of the current commercial property problems.
The moral of the story that there is always a heavy economical price to be paid for major monetary policy mistakes. The excessively easy monetary policy in 2020 and 2021 is no exception.
First, we got multi-decade high inflation. Now the Fed finds itself in the unenviable predicament of having to choose between price stability and financial stability.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
