Macro Minute: The Fed's Illusion of Control

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Spread of Misconception

You've probably heard the quip, "The Fed is always behind. They never see the recession coming." This critique often targets the PhD economists at the Federal Reserve, questioning how, with all their expertise, they fail to predict economic downturns.

But hidden in these remarks is a fundamental misunderstanding: that the Federal Reserve wields omnipotent control over the economy. This myth is encapsulated in the mantra, "Don't fight the Fed."

The widespread belief in the Fed's omnipotence likely stems from two sources. First, Wall Street's psychological scares from when Paul Volcker took the Fed's helm, hiking rates to 20% in June 1981, followed by the severe 1981-82 recession. Second, influential economic schools like the Austrian School and the Chicago School, with figures like Hayek, Mises and Friedman, have long critiqued central banking, viewing it as an antagonist to free markets, an idea popularized further by figures like Ronald Reagan.

So, we have professionals scared by the 1981 events and academics painting the Federal Reserve as all-powerful. But what if I told you this isn't the case? What if the Fed's influence is more about psychological manipulation than mechanical control over the economy?

Reality of the Fed

This morning, a tweet from Bitcoin friend Peter Brandt sparked my thoughts on this topic:

"My problem with the Fed is not so much that it causes volatility, but that the Fed has a pattern of too little too late. The entire Fed board is made up of incompetent PhDs with no market sense @federalreserve"

Brandt, who began his successful commodities trading career in 1976, epitomizes the mindset I've previously discussed. The common oversight here, shared by Brandt and many others, is that the Fed isn't late or doesn't fail to predict recessions; it's that the Federal Reserve simply isn't in mechanical control.

Historically, market rates have always led the charge. The chart above illustrates instances where market yields dropped, prompting the Fed to either pause rate hikes or follow the market's lead downwards.

The same pattern holds when yields rise, although these instances are less pronounced but still evident. Yields bottom out first, with policy rates following suit. The 2016 anomaly, where the 10-year Treasury yield didn't follow this pattern, was likely due to market uncertainty after years of zero interest rate policy (ZIRP), questioning whether the Fed could raise rates from zero.

I chose the 10-year yield for its historical data availability back to Volcker's era. However, examining the 2-year yield clearly shows market rates rising before the Fed's actions, reflecting short-term expectations. Only long-term inflation and growth expectations in the 10-year yield caused this hesitation.

Conclusion

In essence, the Federal Reserve, despite its significant influence, does not dictate market rates but rather reacts to them. This dynamic underscores a critical truth: the Fed's power is aimed at psychologically guiding economic sentiment rather than controlling the economic machinery outright. This perspective challenges the nearly universally-held belief in the Fed's omnipotence, revealing instead a central bank that follows, rather than leads, the complex currents of market dynamics.

Hope this helps someone.

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