The Fed’s Continuing Dilemma

For over a year now, the Fed has been following an aggressive monetary policy of raising interest rates.

As we wrote in our previous letters, their policy path was dictated by their previous mistakes and not by a well-designed forward-looking plan.

While markets focused on the interest rate increases, and the considerable dislocations and disruptions they created (including bank failures), they were slow to acknowledge that other strong factors were opposing the Fed actions and, thus, limiting the effect on real economic activity:

1. The Fed’s delay in acknowledging the effect of its aggressive liquidity easy policy and its inflationary consequences resulted in a huge liquidity injection into the economic system which supports economic activity and strong equity markets. The Fed has so far reduced liquidity in a very limited fashion.
2. The continuing expansionary fiscal policies and the big deficit associated with them act counter to the effect of the tighter monetary policy.
3. Until recently, real interest rates were negative which traditionally supports economic expansion.
4. Following Covid, and amplified by social media, global consumers spending habits have changed. They are paying less attention to saving and their future well-being and rather want to live in the present, especially as they see the good life of people they follow on social media. Thus, an increase in the propensity to spend and consume.

While the tighter Fed monetary policy did trigger market concern and heightened uncertainty as well as a decline in the availability of loans, especially to the housing sector, it had to counter the expansionary factors outlined above and consequently had a limited effect so far on slowing economic growth. The improvement in inflation numbers is primarily due to slowing global economic growth (China), the relief of some supply chain disruptions during Covid and the Ukraine war. Yet, the Fed will need to see a more sustainable inflation decline in the face of strong labor market, robust consumer spending and government deficits, before they can declare victory.

The path forward is presenting a big dilemma for the Fed. From the factors outlined above, only a few are affected by the Fed’s policies. If, as we believe is the case, the Fed wants to eliminate the sources of the inflation impetus, an extended period of positive real interest rates and a more significant reduction of its balance sheet will be necessary. Thus, any market discussion of a reversal of Fed policies (i.e. interest rate reduction) is likely to be premature. To achieve a continuing decline in inflation without triggering a hard landing, the Fed should hold off on rate increases, accelerate the reduction of its balance sheet and let time gradually improve inflation to the Fed’s desired level. Due to its past mistakes, the Fed had to raise rates at a very rapid pace and consequently has not yet benefited from the gradual economic adjustments to tighter monetary policies. In addition, the Fed needs to disassociate itself from the current market fixation with every economic data report as if it holds the compass for future Fed actions.

If the recent inflation decline proves to be temporary and the labor market and spending continue to be robust, the Fed can marginally raise interest rates in a way that keeps them ahead of the markets rather than being led by them. The Fed needs to be more proactive in crafting a plan to successfully navigate their self-created dilemma. Yet, continuing with their history of policy mistakes and ill-crafted messages, Chairman Powell’s latest comments intended to prepare markets for upcoming policy decisions may backfire as a few transitory or random data reports may paint a very different picture than the true trend.