Having failed spectacularly through 2021 to predict the trajectory of rampant inflation, the U.S. Federal Reserve (Fed) has come under fire for doing too much too late — layering on a series of rapid-fire rate increases when earlier intervention might have been more effective. Some critics charge that the Fed kept rates too low for too long in response to political pressure, while others believe that the central bank is simply scrambling to keep up with economic realities it failed to anticipate.
The U.S. Fed wasn’t alone, but as the world’s most influential central bank, its actions influence the policies of all other central banks who have pursued similar policies in recent years.
But cut the U.S. Fed some slack, says Ian Marthinsen, portfolio strategist with Lysander Funds Ltd., an experienced Canadian investment fund manager. It’s acting on imperfect information in an extremely unusual economic environment and has only a few limited, albeit powerful, tools in its tool belt.
“I would say the Fed is doing exactly what its responsibility requires,” he says. “They’re balancing a dual mandate of price stability and full employment and at times the Fed will focus on one more than the other. In this case, the Fed is fighting inflation coming from two fronts — supply side from supply chain issues and rising producer costs, and demand side from a torrent of fiscal and monetary stimulus that have supercharged demand.”
With inflation rates matching 40-year highs, however, the Fed remains concerned that labour demand for higher wages equal to or greater than the inflation rate will create a self-replicating wage-price spiral. The Fed’s delicate task, then, is to use the blunt tools of overnight rate hikes and longer-term quantitative tightening to cool the economy just enough to ease price increases without crushing it — while also dampening labour markets without creating mass unemployment.
But with as few as eight regularly scheduled monthly meetings each year, the Federal Open Market Committee has a limited number of opportunities to guide the market. And each time it makes a policy correction, it does so with imperfect knowledge of the impact of the last change in the overnight rate.
Marthinsen likens these policy lags to a ship’s captain steering a vessel from a windowless room in the ship’s hold. Runners would have to race to the ship’s deck to observe the consequences of each change in course and then run back down to provide observations and direction for new course corrections.
So, with imperfect knowledge of the future, U.S. Fed chair Jerome Powell has made the decision that it’s better to over tighten the economy with aggressive rate hikes than to hold off.
“If he under tightens, the effects on the economy could be catastrophic,” Marthinsen says. “The result may be runaway inflation that will require an even more aggressive series of rate hikes — and more economic pain — over a longer period of time. If he over tightens then the available policy tools can be enacted quickly to reverse course and allow him the potential to orchestrate the perfect soft landing.”
To some extent, however, markets continue to react more to what they believe the Fed is going to do than what it actually does. Even hawkish forward guidance is often parsed to tease out dovish intent. And that’s not entirely the market’s fault.
Marthinsen hearkens back to the 2013 “taper tantrum” when Fed chair Ben Bernanke hinted at a future intention to reduce the volume of Fed bond purchases. Investors reacted in shock by selling bonds amidst concerns that the stock market would follow suit. The Fed’s response — buy more bonds.
If Fed forward guidance in 2021 about transitory inflation were simple poker table bluffs designed to temper markets without pulling any levers, those statements have also hollowed out the market’s faith in the Fed’s predictive powers.
But ultimately, Marthinsen says, the credibility of central banks is less about their ability to predict the future of markets and more about their steadfastness in pursuing policies designed to achieve their mandate — especially when those policies achieve results.
“A November U.S. inflation print of 7.1 per cent indicates that Powell is on the right path to tame inflation,” he says. “Markets tend not to think in terms of good or bad — they think in terms of better or worse. Lower inflation prints are inspiring greater market confidence and a belief that the Fed will do exactly what it said it was going to do to pursue its core mandate.”
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