The last thing the Fed should want is to be caught as flat-footed as it was in 2008.
The last thing the Fed should want is to be caught as flat-footed as it was in 2008.
T here is an old adage that “man plans and God laughs.” If ever there was a demonstration of this phenomenon, it has to be that of the Federal Reserve. The Fed happily continues to give forward guidance of its future policy path and confidently makes economic projections, but those prognostications have a way of being upended by events.
The risk of that appears to be greater today in a world characterized by a heightened degree of economic uncertainty. At its last interest-rate-setting meeting, the Fed belatedly cut interest rates by 50 basis points and confidently predicted that we would have a soft economic landing, with continued satisfactory economic growth, and that inflation would come down toward the Fed’s 2 percent target. It also suggested that it would carry out a series of gradual interest-rate cuts over the next year. It did all of this at the very time that a whole range of major economic risks both at home and abroad were in plain sight, suggesting that earlier and faster interest rate cuts may have been required.
Start with the risks at home. Irrespective of who wins the forthcoming election, our dismal public finances are bound to worsen if either of the candidates fulfills his or her reckless budget-related campaign promises. Kamala Harris is promising a slew of expensive public-spending programs, while Donald Trump is promising large unfunded tax reductions. Given that our budget deficit is nearly 7 percent of GDP, additional spending or further unfunded tax cuts would put our public debt (already 100 percent of GDP) on a truly unsustainable path.
Worse yet, if Trump is elected, we could be well on our way to an economically destructive international trade war. Trump has indicated that he intends to impose an import tariff of 60 percent on China and of 10–20 percent on the rest of our trade partners. If implemented, that would invite retaliation by our trade partners and take us back to the beggar-thy-neighbor policies of the 1930s. Needless to add, regardless of the rights and wrongs of this issue, a deportation of undocumented immigrants on the scale that Trump appears to be proposing (hard numbers are hard to come by) would risk disruptions that would further set our economy back. Many may feel that that is a price worth paying, but it is not a price that can be overlooked.
Yet another major domestic economic risk is the slow-motion commercial-property-market train wreck that is well under way. With office vacancies at record-high levels as a result of more work being done from home, office-building prices in many major cities have fallen by more than 50 percent. This has to raise questions as to commercial-property developers’ ability to roll over the approximately $1.5 trillion in property loans that are due by the end of next year. A wave of property defaults could trigger another round of regional-bank crises given small- and medium-sized banks’ high exposure to commercial-property lending. It is true that there have been some signs of “bargain”-hunting in this sector, which is a necessary part of the recovery process, but the drawback of that is that it involves crystallizing losses that have up to now, at least to hopeful bankers, only been theoretical.
Turning to the risks brewing abroad, two major wars are raging between Russia and Ukraine and between Israel on the one hand and Iran, Hamas, and Hezbollah on the other. There is a real risk that the latter could spread to the rest of the Middle East, which would have major implications for energy prices if it caused oil-supply disruptions in the Persian Gulf. The spike in oil prices that accompanied last week’s Iranian missile attack on Israel was a warning sign.
Meanwhile, the external economic outlook is souring. China, the world’s second-largest economy, now appears to be at the start of a Japanese-style lost economic decade as a result of the bursting of its housing- and credit-market bubble and the continuing consequences of President Xi Jinping’s shift to market-unfriendly policies especially toward the high-tech sector. Meanwhile, in Europe, the German economy appears to have run out of steam, and France and Italy are saddled with highly compromised public finances and with a lack of political willingness to address their budget problems. This would seem to make it only a matter of time before we have another round of the eurozone debt crisis.
As Donald Rumsfeld might have said, these are the known unknowns. However, experience teaches that it is all too often the unknown unknowns that throw a spanner in the works. If ever there was a time for humility and contingency-planning at the Fed, it has to be now. The last thing the Fed should want is to be caught as flat-footed as it was in 2008, when it was contemplating an interest-rate hike on the eve of the Lehman bankruptcy.