Has The Fed’s Monetary Policy Playbook Run Out Of Road?

That brings us to the present situation. The Fed’s target rate is currently pinned to near-zero and, the central bank has signaled that it has no plans to lift rates any time soon. Rising inflation expectations may call the Fed’s bluff and force it to hike rates sooner than expected. But it’s unclear if the current rebound inflation expectations is the start of a regime shift that breaks the back of the secular DD trend. Alternatively, the bounce in pricing pressure may be temporary and fade after so-called base effects related to last year’s pandemic effects wash out of the data.  

We’ve been here before. Forecasts that inflation was about to rebound on a sustainable basis have come and gone. Nonetheless, the secular DD trend endures, and there are some compelling reasons for thinking that nothing’s changed.

For example, inflationistas warn that the surge in the Federal Reserve’s balance sheet is a sign that “money printing” will soon raise inflation for an extended period. The reality is that the sharp rise in money supply has largely driven up bank reserves without a meaningful impact on the real economy. Lending, for instance, remains relatively tame. That’s because the surge in bank reserves has remained trapped in the financial system and has yet to spill over into the wider economy, as Jeff Snider of Alhambra Investments has repeatedly explained and documented in recent years (see here, for instance).

Arguing that the decades-long DD trend has run its course remains premature. If DD persists, the Fed won’t be able to raise interest rates for the foreseeable future. When it does start hiking, and if history holds, the rate hikes for Fed funds will top out at a level below the previous high – roughly 2.5%.

The Fed has other monetary policy tools at its disposal, but these tools have been largely ineffective. That leaves the central bank with a policy dilemma: What does monetary policy look like over the next phase of the business cycle? If history is a guide, rates will only rise modestly, perhaps peaking well below 2.5% before the next recession begins. In turn, with rates already low, the standard plan of cutting rates will have less capacity for stimulating the real economy – a trend that’s been playing out for decades and one that’s set to potentially go into overdrive in the next phase of the business cycle.

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Disclosures: None.

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