Worst of economic storm is still to come

There is good news about inflation – and bad. The good news is that inflation will soon peak and come down to more acceptable levels.

The bad news is that inflation will slow because the Federal Reserve is slamming the brakes on monetary policy. This is likely to produce an economic recession and further stock market losses.

The Biden administration and the Fed have allowed the inflation genie out of the bottle for the first time since the 1980s. The administration did so with passage of its $1.9trillion American Rescue Plan. The Fed did so by keeping its policy interest rate at zero for too long and by allowing the money supply to balloon by about 40% over a two-year period.

The result of the administration and Fed's policy largesse, coupled with COVID-related global supply chain disruptions and Russia's invasion of Ukraine, was a surge in inflation. By June, consumer price inflation reached a shocking 9.1%, a rate we had not experienced in four decades.

Monetary policy produced housing bubble

At the same time, the Fed's excessively easy monetary policy produced bubble-like conditions in the equity, housing and credit markets. By the end of last year, equity valuations reached nosebleed levels, experienced only once before in the past century.

Meanwhile, housing prices rose to a higher level than that before the 2006 housing bust even in inflation-adjusted terms.

Thankfully, the Biden administration and the Fed no longer view inflation as a transitory phenomenon. Instead, the Fed is being allowed to take strong monetary policy action to bring inflation under control.

But now the Fed is becoming overly restrictive. With the economy showing clear signs of slowing, the Fed has raised interest rates in 75 basis point steps rather than by the more normal 25 basis points. Similarly, at a time when the stock and bond markets have already declined by about 20% since January, the Fed is on a path to withdraw market liquidity by as much as $95billion a month.

One reason for expecting that the Fed might soon cause a recession is the fact that the Atlanta Federal Reserve now estimates that in the second quarter of this year, the economy probably contracted for a second consecutive quarter. Another is that the bond market is demanding higher yields for two-year Treasury bonds than it is for 10-year Treasury bonds. Over the past 50 years, this so-called yield curve inversion has been the most reliable predictor of an impending recession.

Among the reasons to fear that we are now headed for a hard economic landing is that mortgage rates have increased at their fastest pace in the past 30 years. The almost doubling in mortgage rates from 3% at the start of the year to nearly 6% now is causing housing demand to crumble as homes become less affordable.

It also has to be of concern that consumer confidence has declined to its lowest level in more than a year. It has done so as households have to cope with high inflation and with big losses in their 401(k)s. Since the start of the year, more than $9trillion in household wealth has evaporated as result of a 20% decline in the stock and bond markets.

Further casting a dark cloud over the economy is the difficult environment for our exporters. As interest rates have been raised, the dollar has soared to a 20-year high, making our exports less competitive abroad.

At the same time, our main trade partners are experiencing difficulties of their own that reduce the size of our export markets. The Chinese economy is stumbling as a result of President Xi Jinping's zero-tolerance COVID-19 policy, while the European economy is heading toward recession as a result of Russian dictator Vladimir Putin's use of natural gas as an economic weapon.

All of this likely means that inflation will soon peak and begin to decline in a meaningful way. It will do so first as a result of the 20% decline over the past few months in international commodity prices in general and in oil prices in particular. It will then do so as an impending economic recession opens up slack in the labor and product markets.

It also likely means that by early next year, we will have a hard economic landing and disorderly financial markets. If that does occur, inflation will be 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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Desmond Lachman

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