As the stock market closes out its worst half since 1970, the Federal Reserve has shifted to a hawkish monetary-policy stance to fight inflation. Not only is the Fed raising its policy interest rate in 75 basis-point steps rather than the more normal 25. It is also on the path to withdrawing market liquidity by as much as $95 billion a month this fall by not rolling over its maturing bond holdings.

Before inflicting unnecessary damage to the economy through slamming on its monetary-policy brakes too hard, the Fed might want to reflect on a doom loop that now is stalking the economy. Not only might a weakening economy adversely affect stock-market prices in a big way — falling stock prices might deal a body blow to the economy. That in turn might set us up for another leg down in the stock market.

Any prospect of a recession strikes the stock market by clouding the outlook for company earnings. The lower prospective earnings are, the lower the price investors will be prepared to pay for a share in those companies.

Prices for many household goods have risen in recent months.
Getty Images

This consideration is all the more important as the market’s price-to-earnings ratio remains considerably above its long-term average. The last thing the market now needs is a downgrade in the corporate-earnings outlook due to an impending recession. It’s especially so when the Fed’s higher interest rates are already causing the price-to-earnings ratio to revert to mean.

The link between the economy and the stock market is a two-way street. While a weak economy depresses stock prices, a weakening stock market can also cause the economy to slow.

A meaningful fall in the market disrupts the economy by wiping out household wealth. Feeling less well-off than before, people cut back on spending to replenish their depleted savings. Earlier Federal Reserve studies found people might cut spending by 3 to 5 cents for each $1 that wealth declines on a sustained basis.

A depressed stock market can also affect the economy by hiking the price at which companies can raise new capital. With rising capital costs and consumers cutting back on spending, corporations find it prudent to scale back their investment plans thereby further depressing the economy.

The Fed would seem to be ignoring the negative wealth effect on the economy at its peril. Already in the first half of this year, around $9 trillion in equity wealth has been wiped out. Making matters worse, the bloodbath in equities has been accompanied by large bond-market losses and by the virtual collapse of the cryptocurrency market. In total in the first half of this year, around $14 trillion of household financial wealth — 70% of GDP — has been erased by lower financial-market prices.

Even using the Fed’s lower-bound estimate of how a loss in wealth affects spending, the loss to date this year could have households paring back their consumption by as much as 2% of GDP. In these circumstances, the last thing the economy needs is a further leg down in the stock market that would cause a further pullback in household spending. This is especially the case with the Fed-induced jump in mortgage rates causing the housing market to crumble.

Last year, by keeping interest rates too low for too long and by flooding the market with liquidity, the Fed both let the inflation genie out of the bottle and produced an equity price bubble. Now the Fed risks inviting a market-economy downward spiral by raising interest rates too rapidly and withdrawing market liquidity at an unprecedentedly rapid rate.

I very much hope that the Fed grasps the risks it is taking with the economy and backs off its excessively hawkish policy stance before it is too late. Given the Powell Fed’s past record of poor policy judgment, however, I would not suggest holding your breath.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly 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.



This story originally Appeared on NYPOST.com