The Fed Does NOT Know Better Than The Market. Here’s Why
Of course, if the Fed can prove that it has the ability to better predict the future than the bond markets it closely follows, then the central bank should take all the time it needs before changing its policy stance.
However, as the financial crises of 2008 and March 2020 so painfully show, the Fed does not know more about the future than everyone else.
Recall that the Fed did not foresee the housing crash and ensuing financial crisis of 2008, as well as how bad financial conditions would get in 2020.
Bear in mind that in both cases, the Fed had already cut rates prior to the crazy market sell offs that define those times. That is, 2 year yields had already peaked, and the Fed had taken their delay, then decided that they should err their policies on the side of markets.
Even so, the large selloffs still happened!
Another way to think of this is:
Had the Fed known beforehand how desperate markets would get for liquidity amidst endless cascades of margin calls and forced selloffs, wouldn’t they have cut rates by more earlier?
Yet, in both 2008 and 2020, the bulk of their rate cuts came after markets started to plummet. Again, the market leads, and the Fed follows.
Consequently, the Fed, by waiting and wanting to be sure before enacting changes to their policy stance, really is actively trying to time the market.
This is made evident by their delay in raising/cutting rates relative to turning points in the 2 year yield, and also by their statements justifying those delays.
In November 2006, Ben Bernanke, then Chairman of the Fed, publicly warned that the risk to the economy lay with further inflation, and not a slowdown in growth, adding that:
“Whether further policy action against inflation will be required depends on the incoming data.” (Emphasis ours)
Does this not sound strikingly similar to investors who say that they will not enter into a position until more data comes in?
Or traders who hold off buying or selling until the “market confirms the move”?
Bernanke made his comments all those years ago in defiance of calls for rate cuts, but what did 2 year yields have to say about it? They peaked in June of ‘06, five months before Bernanke’s comments, then went on to plunge to what were then record lows.
All while risk factors that were the exact opposite of what Bernanke identified coalesced and morphed into a financial crisis that engulfed the world.
Now, it would be perfectly reasonable to say that hindsight is 20/20, and what is written above is invalid because we know now how things panned out. And saying so would be an accurate criticism, because it is very nearly impossible to consistently predict the future with some degree of accuracy.
But, this virtual impossibility is the whole point, as it shows that when it comes to predicting the future, the Fed is just as clueless as the rest of us!
Regardless of their reputation, or what people believe that they can do, the Fed is a collection of human beings looking at the same economic trends and data ( although the Fed does have access to non-publicly available data) as everyone else.
They are susceptible to the same cognitive biases and lack of broader perspective as everyone else, and their current policy framework has them trying to time economic cycles, also like everyone else.
Is it any wonder that they cannot preempt financial crises?
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