When you drive a car, it's a good idea to not only look in the rearview mirror, but also look at the road ahead. The same might be said about the Federal Reserve.
In determining interest rate policy, the Fed would be wise to focus not only on past economic data, but rather on what will happen in the future.
This seems especially true now that we are experiencing a slow-growing commercial real estate crisis at home and China appears to be exporting deflation overseas.
The Federal Reserve and Inflation Data
Today's inflation data showed core consumer price inflation stagnating at 3.8%, which the Fed will likely interpret as enough reason to delay the start of its rate cutting cycle.
After all, the Fed has repeatedly said it will only begin cutting interest rates if it sees data showing inflation is sustainably declining to its 2% target.
With inflation well above its 2% target and unemployment still near post-war lows, the Fed will likely feel justified in keeping interest rates unchanged at their current level of 5.25% when it meets next week.
The Fed needs to see the bigger picture
One reason we believe it would be a mistake for the Fed to keep interest rates high based on retrospective data is that this policy would exacerbate the ongoing commercial real estate crisis.
Over the next 12 months, developers will need to refinance $930 billion in maturing debt. With office prices plummeting due to high vacancy rates, developers would have had a hard time refinancing these loans even at the low interest rates they were originally offered.
With the Federal Reserve insisting on keeping interest rates high for an extended period of time, we are sure to see a wave of defaults on commercial real estate loans.
Underscoring this point is the fact that major real estate developers such as Brookfield and Blackstone have already turned the keys over to borrowers and defaulted on loan repayments.
The key point the Fed seems to be overlooking is that banks in general, and regional banks in particular, are not in a position to absorb large losses on commercial real estate loans.
That's because high interest rates have already caused an estimated $1 trillion in mark-to-market losses on bond portfolios. In addition, losses on auto, home, and credit card loans are also soaring. It's only a matter of time before we see another serious community banking crisis. Given the important role community banks play in lending to small businesses, such a crisis could tip the economy into recession.
China economic crisis
Another reason I think the Fed is on the wrong track with its backward-looking monetary policy is that China, the world's second-largest economy, is currently experiencing the collapse of a huge housing and credit market bubble.
China's economy is now slowing, consumer and wholesale prices are falling, property developers are defaulting on loan repayments and straining its vast shadow banking system.
China's woes could result in exporting deflation to the world. As the world's largest importer of goods, China's woes could put significant downward pressure on international oil and food prices.
At the same time, China's push into exports to stave off domestic overcapacity problems could lead to significantly lower export prices and increased competition from other manufacturers around the world.
In 2008, Fed Bernanke got us into economic trouble by failing to predict Lehman's collapse, so it is all the more inexcusable that Fed Powell appears to be repeating the same mistake by failing to predict the glaring and certain force of deflation.