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The primacy of monetary policy: the Fed’s track record does not bode well

When Janet Yellen, United States Secretary of the Treasury and former Chair of the Federal Reserve Board, said at the annual meeting of the American Economic Association in January 2019, “I don’t think expansions just die of old age,” Ben Bernanke, Dr Yellen’s predecessor at the Fed, shot back saying, “I like to say they get murdered.” Why are these – it must be said quite combative – statements from two former central bank chiefs more valid today than ever?

It’s now very noticeable that inflation in the western hemisphere has recently reached the highest level in 70 years. Having wished for inflation in the past decade, these days, after years of ultra-expansionary monetary and fiscal policy as well as added supply-side issues, exacerbated by the war in Ukraine and COVID-19 policy in China, it can hardly be contained.

While the problem with inflation was for a very long time and until just a few months ago dismissed as “transitory” by Dr Yellen’s successor as Fed Chair Jerome Powell, he is now trying to fight it with massive rate hikes and balance sheet tapering. In an overtly exemplary fashion, he is thereby trying to fulfil his dual mandate of full employment and price stability and is aiming for a soft landing, slowing the economy down to a manageable pace. Realistically, however, it must be said that since 1954 only three out of 13 cycles of interest rate rises in the U.S. did not end in recession. Bearing in mind both the quotes at the top of this piece and the Fed’s track record, one suspects that with every rate hike a drastic increase in the probability of recession is being tacitly accepted, if not intended as the last possible means of curbing demand.

Consequently, there are important conclusions to be drawn for the capital market. Guided by the very transparent communication from the central bank, the market has historically quickly anticipated a shift in the yield curve across all asset classes, including resulting effects on valuations. However, what the vast majority has only just realised in recent weeks, thus contributing to the volatility at the moment, is that the focus on fighting inflation – justified by a still(!) strong labour market – will in the process weaken the economy more than expected and necessitate a further revision of the earnings and price forecasts issued to date. For the bulls out there, the only hope is that, given the primacy of monetary policy, the economy does not come off the worst on this occasion. In this context, a soft landing would be the best of all worlds.

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