Federal Reserve Policies: Gas vs. Brakes
We’re all experiencing, probably on multiple levels, the effects of rising interest rates, slumping housing markets, and other unpleasant side effects of current global central banking policies. Due to an uptick in inflation (among other factors), central banks have concluded that it’s time to step on the economic “brakes,” so to speak, by raising the federal funds rate (which in turn raises interest rates for borrowers) and reducing liquidity (i.e., government securities like bonds) in the market via a process called quantitative tightening, or QT. These actions have so far served to bring inflation down month-over-month, despite a continuing strong jobs market.
What this recent report from Better Markets reveals, however, is that a main source of our current economic woes dates back to Federal Reserve policies enacted in response to the 2008 crash. According to the report’s authors, Dennis Kelleher and Phillip Basil,
“The Fed was so focused on keeping its monetary policy actions ‘accommodative’ and on short-term financial market conditions, it ignored the medium- and longer-term adverse effects of its policy actions as well as multiple warning signs in the analysis of how long and to what level its actions should proceed. This more short-sighted assessment process resulted in an entrenchment of its overly accommodative stance that led to significant risks the economy and financial markets face.”
The Fed has a track record of stepping on the gas when the economy runs into trouble (as it did in 2008 and again in 2020) with quantitative easing, or QE. However, when all the excess liquidity, bailouts (to banks or directly to taxpayers), and cheap debt QE creates starts to pose either the risk of inflation or actual inflation, the Fed then stands on the brakes (or threatens to, as they did in 2013) with quantitative tightening. The issues with this gas/brakes/gas/brakes fiscal policy, as the authors point out, is that banks, businesses and investors alike have come to expect (perhaps understandably so) that the Fed will continue their pattern of bailouts during economic downturns, interspersed with half-hearted attempts at standing on the brakes when the economy starts to level out after a downturn and/or inflation starts to get out of hand.
In other words, there’s never a great time for the Fed to stop QE, from a market perspective. So they basically haven’t over the past 14 years, at least not until Fall 2022.
After 2020 the risks of this gas/brakes fiscal policy became even more pronounced, according to the Better Markets report: “Because the economy was on a continuous upward trajectory and inflation was low, there was little if any assessment of what risks the substantial buildup in debt and entrenchment of cheap-and-abundant money would present in the long run. There was apparently no assessment of what the downside would look like in the event of an exogenous shock or another catastrophic financial or economic crisis…Ultimately, instead of following a principle of ‘hope for the best, but plan for the worst,’ the Fed followed a principle of ‘hope for the best, plan for the best.’”
The Better Markets report really highlights two of the most concerning failures of the Federal Reserve over the past 14 years: a failure to hold and implement a long-term fiscal strategy; and the ‘accommodative stance’ the Fed has taken over the years, i.e., backing off on quantitative tightening when it proved unpopular with the markets.
The report also throws up significant red flags about the overall resilience of the US banking system, which in the past has been heavily reliant on the Fed in times of crisis. For example, in 2020 “Banks really only needed to serve their role as a source of strength and market intermediaries for about two weeks before the Fed stepped in, flooded financial markets with trillions of dollars, and effectively guaranteed all markets.”
The question in my mind is this: if we enter a recession sometime in 2023, will the Fed yet again take its foot off the brakes and step on the gas, as they’ve been doing for the past 14 years? Or will they keep on going with their plans to curb inflation at the short-term expense of the economy, a la Paul Volcker during the 1980s?
If the Fed’s track record is anything to go by, we’re in for a bumpy ride in 2023 and beyond. Fasten your seat belts!