Barron's: The Fed Is Scrambling

Pay attention, folks. You don’t want to be 100% invested in stocks at this moment. Raise some cash just in case.

The stakes are as high as they’ve ever been for the U.S. central bank, which was in its infancy during the Spanish Flu pandemic of 1918, and for the economy and financial markets. For every professional prognosticator who is sure a recession is inevitable, there’s another one predicting that the Fed can combat inflation without reversing economic growth. The disagreement over the inevitability of a recession reflects varying views about the frequency and quantity of coming interest-rate increases; the Fed’s plans for and ramifications of shrinking its monster balance sheet after $5 trillion in emergency bond purchases; and the true state of an economy turbocharged by fiscal and monetary policy and not yet through the pandemic.

The labyrinth of scenarios for how monetary tightening is conducted and plays out is a web of trade-offs that have only gotten more unattractive as inflation surges and economic growth slows from lofty levels. The Fed is late in removing stimulus that, with the benefit of hindsight, was far too excessive, especially in conjunction with massive fiscal aid. The central bank’s largess might have staved off a worse recession and market correction in 2020, when the Covid pandemic first reached the U.S. in force and the economy effectively closed. But it has contributed to an inflationary mess that is getting more painful to address. The risks of a policy failure are big and growing, threatening job losses and market bloodshed to fight inflation, persistently higher prices to avoid recession, and, in a worst-case scenario, all of that at once.

Meanwhile, memories of a disappointing recovery—in which inflation undershot the Fed’s 2% target for years—motivated an overshoot this time. The Fed overhauled its policy framework in the summer of 2020—following a 1½-year internal review and after the economy reopened from lockdowns—to seek periods of higher inflation to make up for stretches of below-target price increases. And then, in September of that year, the central bank gave investors explicit guidance that reflected a departure from the norm: The bank said it wouldn’t raise rates until the labor market hit—versus approached—the Fed’s new, more inclusive but ambiguous assessment of maximum employment, and inflation was on track to “moderately exceed 2% for some time.”

The problem, some critics say, is that the Fed was fighting the wrong problem all along. After all, the crisis playbook was written when the economy was due for a recession. This time, the easy money was dropped on an economy that had been booming, with unemployment at a half-century low. Demand wasn’t the problem, but it has become one. Monetary policy can’t fix supply bottlenecks, but it is hard to dismiss the impact of ultra-accommodative policy on demand that has exacerbated economy-wide shortages.

The constraint on the Fed this time isn’t so much households and business but the amount of debt amassed by the government in recent decades and supercharged by the pandemic, says Georgetown’s Angel. A record $30 trillion in public debt—up about 30% since early 2020—means that even rates topping out at 2% translate to an extra $600 billion a year in interest owed and affect future spending, he says.