Thoughts on the Fed 0.75% Hike
The Fed just raised its benchmark rates by 0.75%. It’s a stunning admission of defeat. They made a mistake and they know it.
The Federal Reserve was fighting the last war and changed course too late. Well actually, two wars. The first one is the deflationary pressure of the past two decades where they struggled to raise inflation even at rock-bottom interest rates and instituted unconventional monetary policy such as quantitative easing. The second one, which is less appreciated, is the culture of forward guidance that was advocated by Ben Bernanke. In 1994 Alan Greenspan started a series of unexpected rate hikes and doubled the interest rate in just 9-months, which roiled financial markets. Ben Bernanke argued that central bankers should not work against the market but work with the market. That is, by making promises about future Fed plans and sticking to them, the markets can do the heavy lifting of monetary tightening and easing. In his own words, “…monetary policy is 98 percent talk and only two percent action” (2015). Bernanke and the two following Fed Chairs (Yellen & Powell) are all strong proponents of forward guidance.
But these two tendencies in the Fed likely led to the debacle that we are facing now. Jerome Powell urged “patience” and argued that the inflationary pressure was “transient”. This was not a bad assessment. After all, the macroeconomic trends that underlie deflationary pressure, such as a declining and aging population, were still there. However, when combined with the policy of forward guidance, they were not only betting that their assessment was correct but it also put the Fed in a bind as to how fast they can move in case the situation changed. This is why even in early 2022, when housing prices were through the roof and inflation has been raging for almost a year, the Fed was still buying tens of billions of dollars of MBSs (mortgage-backed securities) per month. They had to stick to the promises they had made earlier and couldn’t move fast.
Financial markets can change incredibly rapidly. The Fed needed to be nimble. They weren’t. Fed somehow thought that rapidly stimulating the economy in a crisis is okay, but that rapidly winding down stimulus in an overheating economy is not.
It is famously known that militaries tend to fight the last war. In World War I, both sides were completely blindsided by trench warfare that evolved in response to radical improvements in military technology. In World War II, the Allies were again expecting the last war, with the French constructing extensive (but eventually useless) military fortifications along the Maginot Line in preparation for trench warfare.
Is it impossible for the Fed to overcome inertia and do things unconventionally? Not necessarily. Ben Bernanke is an expert in the causes and effects of the Great Depression, and it is commonly thought that his scholarly background led to his drastic actions in 2008 and helped avert a Great Depression v.2.0. Perhaps the takeaway is that looking back way into history may widen one’s perspective and not get sucked into groupthink.
Final question: will this series of interest rate hikes lead to a recession? History seems to suggest so. Larry Summers argued that whenever inflation was above 4% and unemployment was below 5%, there has been a recession within 2 years every single time. However, there are many indications that this recession will be milder than the violent blockbusters of 2008 & 2020, which are fresh in our memories and are likely the only recessions that late millennials and Gen-Z folks have experienced first-hand. First, the banks are more robust and have better risk mitigations in place after the 2008 debacle. Second, households have a lessened debt load, at least partially due to the widespread refinancing of mortgage debt at lower rates and pandemic stimulus checks. Nevertheless, the consequences of the Fed’s missteps will be felt in many households and unfortunately was a preventable blunder.
