The Current Generation of Policymakers Fails At "Knowing When to Fold 'Em"
The current generation of Fed policymakers lacks foresight in knowing "when to fold 'em" or when the balance of risks shifts. Fed Powell has often said that raising official rates before inflation takes hold is essential to avoid future wrenching changes. But Powell did wait, even when inflation spiked to its highest level in decades.
Three successive seventy-five basis points increases in official rates and the expectations by policymakers of another one hundred and twenty-five basis points by year-end are wrenching changes. Although the final results are not in, the sharp sell-off in equity prices and a sharp spike in bond yields is the financial markets' assessment of Powell's delayed response; it will end badly.
In 1994, then Fed Chair Alan Greenspan did not wait. He raised official rates quickly and substantially, even without a pickup in headline inflation, and in doing so, he successfully orchestrated a "soft-landing." Mr. Greenspan used the same language as Mr. Powell. Greenspan said, "if the Federal Reserve waits until actual inflation worsens before taking counter-measures, it would have waited far too long." Consequently, "modest corrective steps would no longer be enough to contain emerging economic imbalances... more wrenching measures would be needed, with unavoidable adverse side effects on near-term economic activity. "
No one can fault Fed Powell for his aggressive accommodative policies of early 2020. An unprecedented decline in economic and financial activity required an exceptional monetary response. Yet, policymakers and analysts misjudged the speed of the rebound and what that could mean for future inflation risks if policymakers did not ease back on monetary stimulus. After plunging a 31.3 annualized record in Q2 2020, the economy registered its most significant quarterly rebound on paper, climbing an astonishing 33.8% in Q3.
The scale and speed of the rebound were a sign that this was a peculiar collapse. Economies don't spring back as quickly if economic issues are the leading cause of downfall. Yet, policymakers reacted to the record rebound in GDP in 2020 with excessive monetary accommodation for another eighteen months, not reversing course until early 2022 and initially in small increments, falling further behind the curve.
It isn't easy to "know when to fold 'em." Yet, institutional rigidities make it even harder. Policymakers only announce policy changes at regularly scheduled meetings and often use the current session to telegraph future changes. Transparency and predictability are essential features of modern monetary policy. Still, they can become policy roadblocks, making the outcome even worse when it is abundantly clear the policy stance is wrong.
For example, housing prices posted double-digit gains in 2020 and 2021, more significant than during the housing bubble. Yet, policymakers continued with their zero interest rate policy and mortgage asset-based securities purchase program until March 2022. Record house price increases signaled a shift in the balance of risks, but the current generation of policymakers ignored them.
Nowadays, the big challenge for policymakers is determining when the balance of risks shifts in the other direction. We are not there yet regarding a restrictive monetary policy, but the signals from the financial markets are increasingly bearish, indicating that the odds of avoiding a hard landing are decreasing with each passing day. Investors should not count on the Fed "knowing when it is time to fold "em".