There is good news and bad news about today's US economy. The good news is that inflation is moderating toward the Federal Reserve's inflation target of 2 percent and the once overheated labor market is finally cooling off. The bad news is that we are not yet seeing the full impact of the Fed's aggressive round of rate hikes on the economy, nor are we yet to feel the consequences of the bursting of the commercial real estate bubble.
This suggests that it is premature for the Fed to declare victory in its goal of a soft landing for the economy.
If there is one thing we know about monetary policy, it is that it operates with long and variable lags between 12 and 18 months. That means the full impact of the Fed's aggressive round of monetary tightening last year won't be felt until the first half of next year. Recall that the bulk of the Fed's 5¼ percentage point interest rate increase occurred in the second half of last year, and the broad money supply is now shrinking for the first time since the Fed began publishing this data in 1959.
If there's one thing we know about commercial real estate bubble bursts, it's that they take time to have their full impact on the financial system. In particular, property owners need time to move from a phase of denial to a phase of acceptance that property prices will have to fall many times over to clear a market characterized by an unusually high post-COVID-19 vacancy rate.
Likewise, a wave of real estate loan defaults generally only occurs when a large portion of the real estate debt has to be rolled over at higher interest rates than those at which the loans were originally taken out.
Next year, the commercial real estate crisis could pose major challenges for banks in general and regional banks in particular. Around $500 billion in real estate loans will mature in 2024 and commercial real estate prices are expected to fall about 40 percent from their recent peak. If a wave of commercial real estate loan defaults actually occurs, many regional banks could fail. This could lead to a significant tightening of credit market conditions, especially for medium-sized companies. This sector accounts for almost half of all economic activity and employment in the United States
The latest data leaves little doubt that the Fed's monetary tightening is working. Over the past six months, the Fed's preferred measure of core price inflation, which excludes food energy prices, was 2.5 percent. That's very close to the Fed's inflation target of 2 percent. The number of job vacancies has now fallen by around 2 million to 8.7 million since their peak at the beginning of 2022.
As good as this news is, it is still unclear whether the Fed will be able to prevent a hard landing for the economy. It's possible that the Fed has engaged in monetary policy overreach over the past year and a half to regain control of inflation. It did so by raising interest rates at the fastest postwar pace and tolerating a tightening of the broad money supply. That means the already slowing U.S. economy could slow even further early next year.
Additionally, a wave of commercial real estate loan defaults could cause many regional banks to fail. This, in turn, could lead to a credit crunch that could plunge the economy into a significant recession.
All of this suggests that the Fed should already be moving away from its mantra that interest rates need to stay higher for longer at its policy meeting next week. Indeed, it does not seem premature for the Fed to begin laying the groundwork for an early turnaround in monetary policy to limit the depth of a potential recession and ease strains on the financial system.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was deputy director in the Policy Development and Review Department at the International Monetary Fund and chief emerging market strategist at Salomon Smith Barney.
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