{J} ames Tobin, the late Yale economist, used a domestic example to illustrate how monetary policy was best conducted. He observed that if someone wanted to set the room temperature at a comfortable level, it was best to maintain a steady hand when using the thermostat. That is to say when the room felt cold, it was not a good idea to swing the thermostat to its warmest setting only then to swing it to its coldest setting when the room began to feel warm. Following that approach would ensure overshooting the desired temperature target in one direction or the other.
If there is one thing that can be said about the Jerome Powell’s Federal Reserve, it is that it has not heeded James Tobin’s sage advice. Instead, it has chosen to pursue an aggressive and strictly data-dependent monetary policy whereby it makes its big interest-rate decisions on the basis of the latest economic data. In doing so, it has forgotten that, like the thermostat, monetary policy also operates with long lags.
Over the past few years, the Fed has swung from an overly easy monetary policy intended to prevent too-low inflation to a highly restrictive monetary policy in an effort to regain inflation control. In the process, it has failed to deliver on the price-stability part of its dual mandate. Risking further damage to its tattered credibility, the central bank now seems to be inviting a meaningful economic recession and real trouble in the financial system by an overly hawkish monetary-policy stance.
At the start of 2020, in an effort avoid deflation from the Covid-induced economic recession, the Fed unleashed an unprecedented amount of monetary-policy easing. Interest rates were rapidly cut to their zero-lower bound, the Fed’s balance sheet was increased by a staggering $4 trillion in the short space of 18 months, and the broad money supply was allowed to increase by a cumulative 40 percent from the beginning of 2020 and the end of 2021. All this monetary expansion was occurring at the same time as the economy was receiving its largest peacetime budget stimulus on record.
Given the size of this monetary-policy stimulus, it was little wonder then — except perhaps to the Federal Reserve — that inflation surged to a multi-decade high. By June 2022, annual consumer price inflation hit 9.1 percent, or more than four times the Fed’s 2 percent inflation target.
Like Professor Tobin’s impatient thermostat adjuster, the Fed has responded to the inflation surge with extraordinary monetary tightening . Over a 15-month period, it jacked up interest rates by five and a quarter percentage points. This has been by far the fastest interest-rate hiking cycle in the post-war period. At the same time, it has reduced its balance sheet by over $1 trillion through quantitative tightening, and it has allowed the broad money supply (M2) to contract for the first time since those records first started to be published by the Fed in 1959.
The main reason to fear that the Fed’s newfound monetary religion will lead to a hard economic landing next year is not simply that the economy is already slowing even before the lagging effects of the recent round of interest-rate hikes and declining money supply have been fully felt. Rather, it is that the sharp rise in interest rates is bound to exacerbate the serious problems already being experienced in the commercial-real-estate space. Those real-estate problems are the result of record-high office and shopping-mall-vacancy rates caused by the Covid-induced shift in work and shopping habits.
At the start of this year, we had the failure of Silicon Valley Bank and First Republic Bank, the second- and third-largest U.S. bank failures on record. The Fed’s high-interest- rates-for-longer approach now threatens to invite another round of the regional bank crisis by hastening a prospective wave of commercial-real-estate defaults. That in turn risks triggering a regional-bank credit crunch that would almost certainly bring on a meaningful economic recession.
All of this suggests that, by not heeding James Tobin’s thermostat advice, the Fed will likely have failed twice to deliver on its price-stability and maximum-employment mandate. Last year, its overly easy monetary policy contributed to multi-decade inflation. Next year, its resort to monetary-policy overkill will likely bring on a meaningful economic recession and a financial crisis.