In 2008, the Federal Reserve was caught flatfooted by the sub-prime loan crisis and housing bust that triggered the 2008–2009 Great Economic Recession. Today, the Fed appears to be making a similar mistake by turning a blind eye to financial system risks in plain sight. Instead, it keeps insisting on the need for high-interest rates for longer to defeat inflation, even when the major trouble brewing in the commercial real estate sector could trigger a new regional bank crisis. By so doing, the Fed is all too likely setting us up for a hard economic landing next year.

The parallels between today and the run-up to the 2008-2009 economic recession are striking. If in March 2008, we had the failure of Bear Stearns, earlier this year, we had the failure of Silicon Valley Bank and First Republic Bank, the second and third-largest bank failures in U.S. history. If in early 2008 we had clear signs of the bursting of a housing market bubble, today we have the clearest of signs of the bursting of a commercial real estate bubble. Worse yet, that bubble is bursting along with other financial market stresses caused by high-interest rates in an over-indebted economy. 

Similarly, if the Ben Bernanke Fed was overly complacent about building strains in the U.S. financial system in the first half of 2008, the same might be said today of Jerome Powell’s Fed. Not only does the Powell Fed largely ignore the financial system risks of its own making. It keeps adding to financial market strains with the most aggressive interest rate hiking cycle in decades. It also does so by withdrawing around $80 billion in market liquidity a month through its quantitative tightening policy. The Fed’s shift from a large buyer of U.S. Treasuries to one that does not roll over its maturing Treasury bonds has been one of the principal factors in the recent spike in the all-important 10-year Treasury bond yield to 5 percent. 

It would be a gross understatement to say that the COVID pandemic has upended the commercial real estate sector. It has done so by permanently changing work and shopping habits. Employers no longer believe their employees must work from the office full-time. Consumers no longer feel they need to shop in the malls. As a result, office vacancy rates have skyrocketed nationally to over 16 percent—a level exceeding its 2008 peak—and shopping malls continue to shut down. This, together with high-interest rates, makes it difficult to see how property developers will manage to roll over the $500 billion in property loans falling due next year at much higher interest rates than those at which those loans were originally contracted.

The last thing that the regional banks need is a wave of commercial real estate defaults. It is not only that such lending constitutes around 18 percent of their overall lending. It is also that these banks are nursing large mark-to-market losses on their bond portfolios as a result of high-interest rates. Needless to add, it hardly helps that their need to offer depositors higher interest rates to maintain their deposits squeezes profit margins.

There are already clear signs that banks are restricting credit in anticipation of having to make increased provisions for loan losses. That process is bound to be exacerbated by a renewed regional banking crisis. This is especially the case since those regional banks are the primary source of finance for small and medium-sized enterprises. 

In pursuing a hawkish monetary policy stance to regain inflation control, the Powell Fed seems desperate not to be judged by history as having been overly tolerant of inflation, as was the Arthur Burns Fed in the 1970s. In its efforts to avoid such a judgment, it is making itself vulnerable to be judged as a Fed that once again largely ignored the financial system risks associated with high interest rates and, by so doing, subjected the public to a deeper economic recession than was necessary to bring down inflation.

About the Author

American Enterprise Institute senior fellow Desmond Lachman 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.

Image: Shutterstock.