Is the Fed doing the right thing?
I can’t tell you how many articles, blog posts and essays I’ve read on this topic. The majority seem to be pretty critical. And I get it. The Fed was slow to recognize inflationary pressures that were building and now they seem to be taking a sledgehammer (primarily, short term interest rate increases, but also forward guidance [essentially telling the market what they’re going to do] and balance sheet normalization [essentially a reversal of quantitative easing]) to the problem. Although, in all fairness, a sledgehammer is really the only tool they have. And they do have a mandate to fulfill (maximum employment and price stability). So, you give an entity a tool and mandate and tell them use the tool to fulfill the mandate and guess what, they’re going to do it.
Most of the criticism seems to be that they’re doing too much too quickly because (a) inflation is already peaking and they’re behind the curve again and/or (b) their tools generally affect aggregate demand whereas, the critics say, the current inflationary spike is primarily caused by aggregate supply constraints. Maybe, but supply constraint driven inflations tend to also increase unemployment (giving you stagflation) which clearly hasn’t happened (yet, anyway). In any event, we won’t have a verdict on this criticism of the Fed’s actions until after the fact.
Contrary to the criticism, though, I think there are clear reasons for their forceful action now including one in particular that does not get a lot of attention in the popular media.
Before we dig into that, let’s pause here for context on why the Fed’s actions now even matter. When the economy is relatively stable (i.e., not now), we really don’t pay too much attention to the Fed. Why? Because if you look at the data, the Fed’s actions (again, during normal times) generally don’t strongly correlate with subsequent market returns. In other words, although it makes headlines, it’s usually just noise. In fact, Warren Buffett once said "If Fed Chairman Alan Greenspan were to whisper to me what his monetary policy was going to be over the next two years, I wouldn't change a thing." Point being, there’s usually not much use in hanging on to the Fed’s every action and word.
But inflation makes things different. High inflation is one of the most corrosive, value-damaging forces in economics. To see an example, just go back to the 1970s. As background, the inflationary spiral back then actually started in the mid-1960s and was accompanied by multiple demand shocks: a large tax cut, significant increase in military spending, enactment of Medicare/Medicaid. In addition, there were significant supply shocks, most notably the 1973 oil embargo. Nixon officially ended gold convertibility in the early 1970s, which was the last vestige of the gold standard (although, contrary to some beliefs, this was more a casualty than a cause of inflation at that time). The point is, there were a lot of inflationary pressures on the economy.
Unfortunately, the Fed, at that time, did not do its job. Between 1965 and 1978, there were two fed chairmen who presided over the economy and neither one appeared to have the fortitude to press hard against inflation. They would raise rates but then pull them down when unemployment ticked up. In addition, the Fed was less independent then than it is now and often appeared to cave to pressure by the White House to ease conditions when the economy appeared to slow down. Because of this, the expectation of high inflation became embedded in the national psyche.
And when inflation expectations go up, you’re in trouble.
When people and businesses begin to expect higher inflation, they make decisions that essentially cause higher inflation. Purchases are accelerated, wages are increased at higher rates, inventories are built up. All increasing prices. Hence the 70s and the economic carnage that resulted. In 2001, Warren Buffett wrote about one victim of this period: the Dow. As he notes, between December 31, 1964 and December 31, 1981 the Dow moved one tenth of one percent… not per year, that was the grand total price gain during that 17 year period. Yeah, inflation is bad.
And so today the Fed is on an inflation-fighting mission with its sledgehammer. And a big part of that is making sure expectations stay in check. Where do expectations sit today? So far, at least, the 10-year expectation appears to be relatively well-anchored around 2.5% (source: 10-year breakeven inflation rate at https://fred.stlouisfed.org/).
That’s good, but clearly the collateral damage is all around. Bonds are having their worst year on record. The stock market is in a bear market. In less than one year, mortgage rates have bounced back to levels not seen in 20 years. All bad, but runaway inflation would be worse. That’s what the Fed wants to avoid. And although the conditions now are much different than they were back in the 1970s, inflation is inflation and the Fed does not want to repeat past mistakes.
So, is the Fed doing the right thing? I don’t know, but at least expectations aren’t out of control. Let’s hope it stays that way.
If you’re interested in reading more about monetary policy in the 1970s vs today, Ben Bernanke’s recent book provides a good summary.
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