The Fed’s Policy Mistake

Eight times a year the Federal Open Market Committee meets to review economic and financial conditions to determine the appropriate positions for monetary policy to maintain full employment and price stability. At its recent March 2022 meeting, the FOMC voted to raise the Federal Funds Rate to reduce aggregate demand in hopes to squelch rapidly rising inflationary pressures.

Fed Chair Powell and the members of the committee seem confident they can reign in the inflationary forces while keeping the labor market at full employment. At the press conference, Powell repeatedly stated the Fed is prepared to aggressively raise interest rates this year and into next year as supported by the dot plots or projections by the committee members.

The bond market has quickly determined that the Fed is making a massive policy mistake by tightening monetary policy. The evidence is in short-term Treasury yields, as short-term Treasury yields are rising faster than long-term Treasury yields. Short-term yields are rising so quickly that some of them are now higher than longer-term yields. When short-term yields are higher than long-term yields, it is a signal that the bond market believes the Fed is tightening monetary policy too quickly.

Under normal economic conditions, long-term Treasury yields should be higher than short-term Treasury yields, and long-term yields should rise faster than short-term yields. When long-term rates are rising faster than short-term rates, the bond market is indicating that growth expectations are rising faster than inflation expectations.

When parts of the Treasury yield curve are inverted, when short-term yields are higher than long-term yields, it is a major warning sign for the economy. An inverted yield curve indicates inflation expectations are rising faster than growth expectations. When inflation expectations are rising faster than growth expectations, it means a recession is on the horizon.

By tightening monetary policy, the Fed is hoping to slow the rate of inflation without slowing growth expectations. According to the Fed’s models, the labor market is tight and consumer demand is strong, which means the economy is likely to remain strong even with a slight pullback in demand. An inverted yield curve indicates the Fed’s policies will have a minimal impact on inflation and a larger impact on growth.

While investors remain overly bullish on stocks and prospects for future economic growth, the yield curve suggests otherwise. The stock market tends to peak within a few years of the yield curve inverting as the stock market finally comes to the truth with the yield curve implying that growth expectations are slowing. With parts of the yield curve inverting faster than normal, it appears the peak in stock prices for this cycle is already in.

The Fed does not want to push the economy into a full-blown recession, and while a mild recession would help bring inflation down, the bond market is signaling that tighter monetary policy will cause a recession. The Fed believes high inflation is largely due to demand being greater than supply, but the bond market is indicating that the issues driving inflation cannot be solved simply by reducing demand.

The bond market is attempting to tell the Fed that inflation is likely to remain elevated for longer than anticipated and that curtailing demand will not have much of an effect on what is driving consumer prices higher. Unfortunately for the Fed, they cannot see the future even when the yield curve is predicting a major monetary policy error is being made.

The problem for the Fed is they can never see a dollar shortage coming. Rather than attempting to curtail demand to solve inflation, the proper policy move would be to increase the number of dollars in the financial system to give consumers the ability to pay for higher prices. Without the tools or ability to print money, the Fed is powerless when it comes to dealing with dollar shortages.

Instead, consumers will do what they always do when faced with tighter monetary policy and a dollar shortage, which is to reduce spending. Reduced spending will lead to inventory build-ups, and ultimately layoffs as fewer employees are needed. The economy will enter a recession, as predicted by the yield curve, which will force the Fed into lowering rates and expanding its balance sheet before another financial crisis threatens to crash the entire financial system.

In an ideal situation, the Federal government would resume direct-to-consumer fiscal stimulus payments and the Fed would ease monetary policy to give consumers the chance to deal with high inflation. Neither of those options is on the table as policymakers believe both fiscal and monetary stimulus led to higher inflation.

With too few dollars in the system, another financial crisis remains inevitable. It will be up to the financial system to create the necessary dollars, which is why Treasury yields will crash across the curve to new all-time lows as an inverted yield curve is predicting.

History will show that Fed Chair Powell made a huge policy mistake by easing monetary policy for too long and tightening too quickly. In the end, the Fed will get what they want, which is lower inflation. Unfortunately, the sacrifice will be another financial crisis that many Americans are are ill-prepared to face.