There was some good news and some bad news coming out of yesterday’s Federal Reserve interest rate-setting policy meeting.

The good news is that the Fed now seems to have grasped that the economy is slowing and that inflation is on a decidedly downward path. The bad news is that the Fed has yet to recognize the importance of the unusual money supply contraction now taking place and the severe risks that its hawkish policy stance is posing to the financial system. This makes it all too likely that, in much the same way as in 2021, the Fed was behind the curve in raising interest rates to fight inflation. Next year, it will be behind the curve in lowering interest rates to prevent the economy from experiencing a meaningful economic recession. 

Bowing to mounting evidence that the economy is slowing and inflation is likely to become yesterday’s problem, the Fed is now backing away from its oft-repeated mantra that interest rates need to stay high for longer to regain inflation control. Indeed, the Fed has now lowered both its inflation and economic growth forecast for next year in a way that suggests that the Fed is satisfied that it is not far from reaching its 2 percent inflation target. At the same time, the members of the Federal Reserve’s Open Market Committee (FOMC) are now penciling in between two and four interest rate cuts for next year. By doing so, they are sending the clearest of signals that the Fed is most likely done with its interest rate hiking cycle. 

While there is reason for encouragement from the Fed now entertaining the idea that interest rates might need to be cut next year, one has to be disappointed that Fed Chair Jerome Powell is yet to recognize that the cumulative 40 percent increase in the broad money supply that occurred between the start of 2020 and the end of 2021 might have much to do with inflation’s surge to a multi-decade of 9.1 percent by June 2022. Rather, Mr. Powell continues to insist that last year’s inflation surge was mainly the result of supply-side shocks from Covid and Russia’s invasion of Ukraine that had nothing to do with the Fed.

With this view of the inflationary process, it is perhaps not surprising that the Fed is choosing to turn a blind eye to the fact that the broad money supply (M2) is now declining by over 3 percent due to the Fed’s hawkish policy stance. Never mind that such a contraction is unprecedented in the sixty-five years since the Fed started publishing these numbers. Never mind, too, that this contraction could be the harbinger of actual deflation next year in much the same way as the earlier ballooning of the money supply was an early warning sign of the recent burst in inflation. 

A further reason for disappointment with yesterday’s Fed meeting was that it did not mention the risks its high-interest rate policy poses to the financial system in general and to the regional banks in particular. This is all the more regrettable at a time when the banks have large mark-to-market losses on their bond holdings as a result of the spike in interest rates and when there is every sign that the commercial real estate sector is in serious trouble because of record vacancy rates in a post-Covid world of changed work and shopping habits. It seems to have escaped the Fed’s notice that we could be on the cusp of a wave of commercial property loan defaults next year when $500 billion in property loans fall due at much higher interest rates than those at which those loans were initially contracted.

In short, it is encouraging that the Fed is beginning to appreciate the downside risks of its newfound monetary policy religion. However, there are many reasons for thinking that next year, the Fed will again be doing too little and too late to meet its dual mandate of price stability and maximum employment. 

About the Author 

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.