Why did the Fed fall behind the curve?

Last Wednesday the Federal reserve decided to raise interest rate first time since 2018. While a much-expected move, this stance reverses Fed’s monetary policy positioning, since then and especially since 2020 when the pandemic hit and the interest rates were brought close to zero. While the context is very complicated, with Russian invasion of Ukraine in progress and inflation surging high, most of the market seems to agree that a hike in interest rate is required at this time. It seems many market-participants (some reluctantly) agree that Fed, this time around has fallen behind the curve. In retiring the phrase “transitionary” the Fed in fact seems to agree to that.

So, I believe it is prudent to move ahead from the question of “Has Fed fallen behind the curve?” to the question of “Why did Fed fall behind the curve?”

If we are to deal with a similar situation again in future, it would be stupid to not know this answer. Unpreparedness can be forgiven for once, but never twice.

Upfront I have to admit that I do not know the answer to that question. But I do have a few theories.

Been there, done that! Or, have we?

One thing that was good with this round of handling of a recession and initiation of the new round of QE was that this was not the first time we would have taken this path. Familiarity was to be on our side. And that typically means a lot. Lessons learned in the past can come handy - do things that worked, avoid things that didn’t work. All of that is great if the context remains the same. However, if the context somehow is different and we don’t realize it, it may be a recipe for divergence (in average case scenarios) and disaster (in worst case scenarios). I believe, something like that happened. Let me explain by comparing the two crisis we face in the last two decades.

A crisis is typically a dislocation in some part of the world - typically somehow connected to our financial markets. The financial crisis was a dislocation in our financial markets while the pandemic (a health crisis) was a dislocation that started with an impact to people’s health, impacting our healthcare system, and then impacting our travel and trade systems (when preventative measures were put in place - whether voluntarily or as mandated by state actors).

Posture - Winner or Looser?

The financial crisis was a crisis that happened in a system that was designed by us. It had no extraneous causalities. The system went into a crisis mode, but we were eventually able to stabilize the system and not let it crash. Even though we were “successful” in saving the system, and eventually make modifications to it so that it would not encounter such a situation again (hopefully), we were never able to gain the same level of faith in the system, for a long period of time. We emerged out of the financial crisis as losers, who were lucky enough to be able to survive. And by “we” I mean the collective imagination of the entire human civilization. Eventually though, faith in the system would get restored, although some of that faith being delivered more towards the tech-onomy.

In contrast to that, what happened during the pandemic was very different - the source of the virus was extraneous (as far as the popular belief goes), at least to the western economies. It came in from outside, and our healthcare companies were able to identify the solution and get it delivered in record time. Even though the enemy kept on coming back in wave after wave, each wave was eventually beaten. Even though there was a dislocation, the dislocation we had backups that kept us going - the technologies we had developed in the last decade or so enabled us to do remote work. These two factors meant that the virus’s damage to our system was relatively limited as compared to what it could have done. The dislocation was also short-lived. All in all, it meant that we emerged out of the Covid pandemic as winners. That is especially true for those in the west with access to vaccine such as Pfizer and Moderna.

This difference in mentality or posture means a lot.  It means that getting back to normal is a lot easier. It means there is a lot more confidence that we’ll be able to get back to normalcy, as compared to the scenario post-financial crisis. The secondary waves that followed the financial crisis continued to shake confidence - the European debt crisis, the Chinese market crash and so and so. We’re definitely not past the final chapter with Covid, but as of this writing, the confidence of a win still holds strong. This makes the demand-side extremely strong.

Asymmetry in structural issues

What we looked at above is an important part of the story, but it is not the complete story. For that we need to connect the demand side to the supply side. While it is going through a lot of fracturing, the global economic system is fairly well inter-connected. However, because of income asymmetries, the system is not uniform. The west has become overweighted on the demand side while the east has become overweighted on the supply side. Furthermore, cost-economics over time has resulted in a much-structured supply side (which to some extent will always be the case), while free-market policies and consumerism keeps the demand side relatively agile and dynamic. Under such circumstances, adaptation in the demand side will always be much faster as compared to supply side. These structural asymmetries will always result in a lag factor between supply and demand. To add to that mix, we also have geo-politics. The entire scene has become much different as compared to the days after the financial crisis.

A rotten cherry on top of an ugly cake

While all of this was going on, and when the world least needed it, came in the Russian invasion of Ukraine. Here is another shock to an already dislocated global system. Even if deflationary forces were trying to find a foothold to fight off the enemy, it got completely blown off by what happened in Ukraine. Unless this is going to result in a lagged demand shock, this will make the scenario worse for the Fed.

Conclusion

All of this may be difficult for anyone to foresee. Be it Fed or another institution. Of course, it will eventually show up in the data, but by then it might be too late - which is likely what the case is.