Milton Friedman famously taught that monetary policy operates on a long and variable time lag, meaning that we should expect the effects of raising or lowering interest rates to occur after a long lag, rather than immediately.
One implication of Friedman's teachings is that if the Fed waits for the clearest signs that the economy is cooling and inflation is falling, it is likely to wait too long to avert a recession. If the Fed belatedly lowers interest rates, it will not have enough time to halt the economic slowdown. This seems especially true now, as the Fed's high interest rates, in addition to curtailed spending by households and businesses, damage the financial system and dark clouds gather over the global economy.
In recent congressional testimony, Fed Chairman Jerome Powell acknowledged that the economy is slowing and the labor market is no longer overheating. Meanwhile, the consumer price inflation figures released today were welcome, indicating that inflation continues to run below the Fed's inflation target. Not only did consumer prices actually fall last month, but inflation also came in below economists' expectations.
As if a slowing economy and subdued inflation weren't enough reason for the Fed to cut interest rates, problems are brewing in the financial system in general, and regional banks in particular. As a result of the Fed's 5.25 percentage point interest rate hikes since March 2022, banks have suffered more than $1 trillion in mark-to-market losses on their bond and loan portfolios. At the same time, the Fed's high interest rates are exacerbating problems in the commercial real estate sector, which is suffering from record vacancy rates as a result of changes in work and shopping habits caused by the COVID-19 pandemic.
The Federal Reserve seems unaware that another community banking crisis could be reminiscent of the savings and loan crisis of the late 1980s, which contributed to the economic downturn of 1990 and 1991. As if to underscore this point, a recent study by the National Bureau of Economic Research estimated that nearly 400 small banks could fail due to their heavy investments in commercial real estate and bond and loan portfolios driven by falling interest rates.
Another reason the Fed is lowering interest rates now is the deterioration of the global economy. China is in the midst of the collapse of a huge housing and credit bubble. Europe appears to be on the brink of a new sovereign debt crisis as France becomes ungovernable and Italy continues on a path of unsustainable public debt. Meanwhile, Japan is struggling with an exchange rate that appears to be plummeting.
All of this suggests that the Fed should cut interest rates. However, with the November election looming, the Fed will likely be reluctant to do so at this point for fear of being accused of being politically motivated. This would be a great shame, as by the time the Fed finally acts, the recession train will likely have long since left the station.
About the Author: Desmond Luckman
Desmond Luckman is a senior fellow at the American Enterprise Institute, deputy director in the Policy Development and Review Department at the International Monetary Fund, and chief strategist for emerging market economies at Salomon Smith Barney.
Image: Shutterstock.com.