Bernstein: The Fed Will be Behind the Curve When It’s Time to Tighten

Richard Bernstein’s latest research piece has a view that I very much agree with.  The Fed is traditionally a reactive entity.  When the economy is running hot they tend to lag the market and tighten too late.  When the economy is running cold they show up late to the party as they did in 2008.  On both sides they end up playing catch-up which results in whip-sawing the economy in a way that actually causes more economic volatility than necessary.

Richard Bernstein expects this cycle to end the same way.  He says:

“The Fed believes that reversing QE will slow the economy. However, a steeping yield curve and stronger business confidence argue otherwise. If we are correct, then the Fed could once again be forced to play catch-up to the markets during the mid- and late-cycle.As most cycles mature, the Fed typically realizes that their policies have been too accommodative for the maturity of the cycle. Production bottlenecks and shortages become more frequent, and inflation pressures begin to build. The Fed then rushes to tighten monetary policy in an attempt to make up for the earlier hesitancy to tighten. The traditional end result has been that the Fed’s late-cycle aggressive policies go to far (i.e., they over-tighten policy), the yield curve inverts, and a recession follows.

This cycle seems poised to follow that historical pattern. The Fed remains fearful of tightening too early and has told investors that they will react to the economy’s strength. Their reaction time will probably be slow as well. If our contention that reversing QE might stimulate the economy is correct, then the frequency and magnitude of Fed tightening is likely to accelerate as they realize they’ve created a monster. Their rush to equalize monetary policy with the strength in the economy could lead them to over-tighten and invert the yield curve. A recession would probably follow, and the cycle would end in a very traditional manner.”

That makes a lot of sense given this cycle.  We’ve seen such a historic easing program that the Fed is going to be very hesitant unwinding the program.  They want to be completely certain that the economy is healed before they jump the gun.  And by the time they do that they’ll almost certainly be behind the curve as a disequilibrium will already be building up in the economy.

We live in a boom/bust era dominated by Fed policy.  In my opinion, we can thank Milton Friedman for this obsession with Fed policy and the assumption that the Federal Reserve and a group of economists can control the economy with any sort of precision.  The 30 year experiment with the Federal Reserve’s interventionist policies is far from over.