The Fed’s Continued Missteps

Over the last several years, the US economy has been driven by the amplifying effects of the Fed’s policy measures. The Fed misjudged the evolving economic and geopolitical situations which led to delayed responses, at best, and wrong market signals, at worst. Thus, rather than being ahead of the curve, the Fed found itself often behind the curve.

While the root of their current poor decisions lies in the past, I would like to emphasize their current missteps. The past misjudgment of the effects of ample liquidity and the extended period of zero interest rates, as well as the inflation surge following Covid and the Ukraine war, triggered delayed yet accelerated interest rate increases. Rather than focusing on the underlying factors for inflation and economic growth, the Fed and the markets choose to focus on the speed of the Fed rate hikes, thus once again losing sight of the big picture.
Inflation is likely to be with us for an extended period with economic growth, despite divergent patterns across the global economies, likely to continue its strong momentum in the US.

The US economy is strong since liquidity is still abundant, despite the Fed’s accelerated interest rate increases. To be effective, the Fed needed to accompany its interest policy with the draining of the ample liquidity it injected in the previous years. Yet, it drained far less than what was needed due to the regional banking crisis. Furthermore, the extended favorable liquidity situation enabled many companies to improve their balance sheets and, thus, made industries and companies which are not leveraged (like high-tech) less sensitive to the higher rates and limited the Fed’s effect on slowing growth. The declining effect of contractionary monetary policy on economic growth was further diminished by the continuing expansionary fiscal policy and high government deficits. While every economic cycle is affected by whether fiscal and monetary policies are in sync or not, there is a behavioral shift that is unique to the current cycle. Following the period of Covid and its suppressed spending, consumers reacted with a “spring like effect”, looking to compensate for the difficult period and reflecting their shift to “live now” which led to a higher willingness to spend. In addition, economic growth is also fueled by the wealth effect, courtesy of the strong stock market, which is partially due to the Fed’s missteps.

The other aspect of the Fed’s misjudgment involves the inflation situation. As we mentioned in our past writings, the main impetus of the global shift to a more inflationary period is due to the change from globalization to deglobalization, where geopolitical tension forced bringing production back home and not focus anymore on lower production costs abroad. The rise in current geopolitical tension is likely to accelerate this trend. While some transitory inflationary pressures, such as the supply chain disruptions due to Covid and the Ukraine war, have diminished and are responsible for the recent decline in inflationary pressures from their overextended levels, the more permanent inflationary factors due to deglobalization and economic growth are likely to stay relevant in the foreseeable future.

The Fed’s policy measures had a short-term effect, primarily on the equity markets, due to the speed and not the level of rates. Once monetary policy tapered off, equity markets stopped focusing on monetary policy and shifted their focus to economic strength and corporate performance. Furthermore, the Fed triggered another wave of stock market rallies once it

February 2024

broadcasted that it was finished with more interest rate increases (misstep #1). The Fed seems to forget that there are long lags in the effect of monetary policy and an extended period of positive real interest rates may be required to achieve its goals (misstep #2). The Fed declared victory on the inflation front, failing to recognize longer term inflationary factors (misstep #3). The Fed failed to acknowledge and act on the ample liquidity that still exists in the economic and financial system (misstep #4). Fed members continue to speak frequently and respond to transitory data, confusing rather than reassuring the markets (misstep #5).

The effects of the Fed’s missteps are amplified by their failure to recognize and address their past misjudgments. Until they do so, they will remain behind the curve and reactive with little impact on inflation, and their policies will not achieve their desired effect.