Fed Thoughts

The Fed recently eluded to the "normalization of its balance sheet" or quantitative tightening. The Fed has communicated this tightening will commence "relatively soon" potentially while short term interest rates are still in the hiking phase. I find this perplexing. The Fed's dual mandate is employment and inflation. Employment likely cannot go much lower, but the lack of significant wage pressures give comfort that the labor market is not overheating. Inflation is barely approaching the 2% target, and with the exception of a few years in the mid 2000s, has been at 2% or below since the early 1990s. Technology and globalization have smoothed out inter-regional economic links and muted inflation's effects in developed markets. If anything, growth expectations in the US have come down since the beginning of the year. One could even argue there is little justification for interest rate hikes in general (although this is not my opinion). The Fed has proven adept at tightening in a cautious manner, as it has completed 4 interest rate hikes without harming the underlying economy or financial markets. It plans additional rate hikes over the coming quarters and years, so why does it need to shrink its balance sheet at the same time? Might it be biting off more than it can chew? One reason for concern is that easy financial conditions are encouraging recklessly risky behavior, and asset prices are too inflated - becoming more susceptible to a market crash that could reverberate in a negative feedback loop to the real economy. However it is not the Fed's mandate to dictate fair value of asset prices, that is the job of capital owners. Inflation, growth expectations, and credit growth have been trending downward, so why is the Fed worried? Perhaps the Fed still has too much faith in the Phillips Curve model and its link between inflation and unemployment. A model that has seldom been of use in recent times. During the Great Depression, the Fed balance sheet grew significantly, but they did not shrink the balance sheet in the decades after, simply allowed the economy to grow out of the problem to a point where the balance sheet was no longer relatively elevated. The Fed risks tightening credit conditions too much during the late point in the business cycle with an economy experiencing limited credit growth with only modest growth and inflation.

I understand the impetus for the Fed to "normalize" early. Their ultra low monetary experiment and quantitative easing programs have gone on longer than anyone anticipated. They worry as a result, asset prices have surged to scary levels. They take undeserved political flack and are seldom credited for the job they have done thus far. Pundits dismiss the backstop they provided the economy since the Financial Crisis, and ignore the counter factuals of what may have transpired if the Fed had not acted. They fear they will again be the scapegoat for the irresponsible behavior of participants outside their control. Yet look at how the US economy has performed relative to the rest of the world? It has not done so bad. I'm not proposing interest rates have to stay low forever, and gradual hikes are reasonable. Do not obsess over the years policy has stayed easy compared to other time periods because without context it is meaningless. The message is: don't do more than is called for by market conditions. Why not simply continue hiking short term rates until they reach terminal value, and if the economy shows actual signs of overheating - add the quantitative tightening element then. The Fed has proven its ability to fight inflation since Volker. It should allow credit to flow through to the real economy while modestly hiking rates, and be confident that if and when inflation becomes a problem, it has the ability to deal with it.  "Don't fire until you see the whites of their [inflation] eyes."