A crisis takes a much longer time coming than you think but then happens much faster than you would have thought.
There are several warning signs that the Fed's aggressive monetary policy is going too far.
R udi Dornbusch, the late MIT economist, used to say that he could understand the Mexican central bank making mistakes. What he could not understand was how the same people could make the same mistakes time after time. Judging by how little attention the Federal Reserve is presently paying to looming financial-market risks, one has to wonder whether the same thing might not be said of the Fed as was said of the Bank of Mexico.
In 2008, did the Fed not get the economy into deep trouble by ignoring the financial-market risks posed by a housing bubble and a surge in subprime lending? Might the Fed now be repeating the same mistake by hewing to an aggressive monetary policy at a time when financial-market risks are in plain sight?
In March 2008, Bear Stearns’ subprime-induced collapse turned out to have heralded a full-blown U.S. financial-sector crisis later that fall. Fast-forward to earlier this year, and we have had the interest-rate-induced failure of First Republic Bank and Silicon Valley Bank, the second- and third-largest U.S. bank failures on record. Yet this has not stopped the Fed from compounding financial-sector strains by continuing to hike interest rates at the fastest pace in the past 40 years.
The Fed’s seemingly sanguine attitude towards brewing financial-market risks is all the more surprising considering the very large size of the marked-to-market losses that its interest-rate policy has already inflicted on the banking system’s bond portfolio. According to a recent National Bureau of Economic Research study, the U.S. banking system’s market value of assets is $2 trillion lower than suggested by their book value. The study estimates that across all banks, marked-to-market assets have declined by around 10 percent as a result of higher interest rates.
Equally disappointing is the Fed’s failure to notice a brewing full-blown crisis in commercial real estate. It is estimated that these loans amount to as much as 18 percent of regional banks’ overall balance sheets.
There are already signs of commercial-real-estate distress. Following the pandemic, many workers are choosing to work from home. That is leading to high vacancy rates and is causing a sharp drop in commercial-real-estate prices. According to a recent study by Capital Economics, those prices could decline by as much as 30 percent in six major U.S. cities. More colorfully, according to a Harvard and an MIT housing expert, New York has empty office space equivalent to 26 Empire State Buildings.
It has to be of deep concern for an already shaky financial sector that over the next three years as much as $1.5 trillion in commercial real-property loans fall due. At a time of high vacancy rates, it is difficult to see how the higher interest rates at which the new loans will need to be rolled over will not lead to a wave of defaults. As a sign of things to come, commercial property borrowers are already increasingly choosing to walk away from their loans and leave the banks with the distressed properties.
Repayment problems as a result of the Fed’s unusually rapid pace of interest-rate increases will not be confined to commercial real estate. Similar problems must be expected to surface in bank lending to the highly leveraged companies, automobile purchases, and the emerging market economies. This will only add balance-sheet strain to the already troubled banking sector.
Before thinking about any further interest-rate hikes, the Fed would do well to heed another of Dornbusch’s teachings. Dornbusch never tired of reminding us that a crisis takes a much longer time coming than you think but then happens much faster than you would have thought.