There is good news and bad news about today’s U.S. economy. The good news is that inflation is moderating towards the Federal Reserve’s 2 percent inflation target, and the once overheated labor market is now finally cooling. The bad news is that we are yet to see the full effect on the economy of the Fed’s aggressive round of interest rate hikes and to experience the fallout from the bursting of the commercial real estate bubble.
This suggests that it is premature for the Fed to declare victory in its goal of a soft economic landing.
If there is one thing we know about monetary policy, it is that it operates with long and variable lags of between 12 and 18 months. This means that it will only be by the first half of next year that the full effects of last year’s aggressive round of Fed monetary policy tightening will be felt. It might be recalled that the major part of the Fed’s 5 1/4 percentage point interest rate hike occurred in the second half of last year and that the broad money supply is now contracting for the first time since the Fed started publishing this data in 1959.
If there is one thing we know about the bursting of commercial property bubbles, it is that it takes time for their full effects to work their way through the financial system. In particular, it takes time for property owners to move from a stage of denial to one of acceptance that property prices will need to fall by a large amount to clear a market characterized by an unusually high rate of post-COVID-19 vacancies.
Similarly, we generally get a wave of property loan defaults only when a large amount of property debt has to be rolled over at higher interest rates than those at which the loans were originally contracted.
Next year, the commercial property crisis could pose major challenges for the banks in general and for the regional banks in particular. Around $500 billion in property loans mature in 2024 and it is likely that commercial property prices will fall by around 40 percent from their recent peak level. If we do get a wave of commercial property loan defaults, many regional banks could fail. That could lead to a substantial tightening in credit market conditions, especially for the small and medium-sized business sector. That sector accounts for close to half of all U.S. economic activity and employment
The latest data can leave little doubt that the Fed’s monetary policy tightening is working. Over the past six months, the Fed’s favorite measure of core price inflation, which excludes food energy prices, has been running at 2.5 percent. That is very close to the Fed’s 2 percent inflation target. Meanwhile, job openings have now fallen by around 2 million from their early 2022 peak level to 8.7 million.
As good as this news is, the jury remains still very much out as to whether the Fed will succeed in avoiding a hard economic landing. It’s possible that the Fed has engaged in monetary policy overkill over the last year and a half in its effort to regain control over inflation. It did so by raising interest rates at their fastest pace in the post-war period and by tolerating a contraction in the broad money supply. That means that an already slowing U.S. economy could slow further early next year.
Also, a wave of real commercial property loan defaults might cause many regional banks to fail. That in turn could lead to a credit crunch that could tip the economy into a meaningful recession.
All of this suggests that at its policy meeting next week, the Fed should back off already from its mantra that interest rates need to stay high for longer. Indeed, it doesn’t seem premature for the Fed to start laying the groundwork for an early monetary policy U-turn to limit the depth of a possible recession and to reduce the strains on the financial system.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was 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.