Has the Fed learned its lesson?
Discussing the U.S. Federal Reserve is not your typical go-to topic of conversation at the office water cooler. For laughs, ask your colleagues their thoughts on the latest Fed meeting and watch the blank stares appear. Your membership to future water cooler discussions will likely be revoked. But the Fed’s impact is expansive, ultimately impacting most every facet of our daily financial lives.
As America’s central bank, the Federal Reserve serves as the decision-making body for U.S. monetary policy. Its mandate is to promote the health and stability of our financial system. Through management of short-term interest rates and the availability and cost of credit, it seeks to manipulate spending, investment, employment and inflation to foster economic growth.
The Fed’s main tool in this endeavor is to adjust the benchmark fed funds rate, upon which short-term debt is often based. Lowering interest rates on credit induces consumer and business spending, helping boost economic growth. Conversely, raising the cost of debt acts as a deterrent on spending and taps the brakes on economic growth.
While implementing its rate hike agenda, the Fed must walk a tightrope of balancing economic growth and inflation (rising prices). The ideal pace allows for a steadily growing economy that keeps excessive inflation in check through targeted and measured rate hikes. If the Fed raises rates too fast, it risks prematurely stalling economic growth. Too slow, the Fed risks the economy overheating with runaway inflation.
But the Fed is still reeling from its alleged mismanagement of interest rates over the past two years. In 2018, at a time when the U.S. economy was weighed down by a severely weak global economy and trade disputes, the Fed charged ahead with four 0.25% rate hikes. Moreover, the Fed was further projecting two to three additional 0.25% rate hikes in 2019.
The resulting chaos was brutal. On concerns the Fed would de-stabilize a strong and growing economy with its aggressive agenda of interest rate hikes, the Dow Jones Industrial Average plummeted nearly 19% from Oct. 3 through Dec. 24, 2018.
Last year, the Fed spent much of its time undoing the interest rate hikes it had imposed in 2018. First, the Fed eliminated its two to three projected rate hikes in 2019. It then enacted a series of three consecutive 0.25% rate cuts beginning at its July meeting. In short, the Fed was implying that the four rate hikes in 2018 were a mistake, without explicitly saying so.
In hindsight, the Fed’s greatest fault was its stubborn reliance on its economic forecasting models. The Fed uses its theoretical models to project the future dynamics of the U.S. economy, such as economic growth, employment and inflation. These models were telling the Fed that the strong economy, labor market and rising wages would drive inflation higher to unacceptable levels – something that never happened. Despite acknowledging this disconnect between its models and real-world data, the Fed pushed through its four 0.25% rate hikes in 2018 amid rising anger from both Wall Street and Main Street America.
As we begin 2020, the Fed appears more even-keeled in promoting its interest rate agenda. It’s been less aggressive in its public commentary and seems to be taking a more wait-and-see approach in delivering its interest rate forecasts. The role of the Fed should be “behind the scenes”, using its monetary policy to gently guide and stabilize the economy on a gradual upward trajectory. In recent years, its actions have hindered, not helped, that upward trajectory. This year, let’s hope the Fed has learned from its prior mistakes.
Mark M. Grywacheski, Investment Advisor
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Quad Cities Investment Group, LLC is a registered investment advisor with the U.S. Securities Exchange Commission.
