The Federal Reserve’s Dovish Days are Suspended: Investors Should Brace Hard for the Hawk

9 Pages Posted: 30 Mar 2022

Date Written: February 5, 2022

Abstract

Over the past several months, the Federal Reserve’s Federal Open Market Committee (FOMC) and several Presidents of Federal Reserve regional banks issued statements supporting the Fed’s intent to tighten monetary policy until inflation stabilizes at the long-term target of approximately 2%. However, given the Federal Reserve’s recent history of retreating when monetary tightening causes too much anxiety in financial markets, investors may underestimate the severity of what may be coming. The Fed’s implicit put, which softened the blow of prior tightening cycles, may no longer be in force. This may allow price declines in risk assets to progress beyond the point to which many investors are accustomed.

This paper details three reasons why the Fed will likely back its hawkish messaging with actions that are less forgiving than those employed over the past several decades. The first reason is that the Fed is currently confronting a fundamentally different set of economic conditions, which render the monetary policies of the past several decades inappropriate bases for comparison. Present conditions simply do not provide sufficient margin of safety for the Fed to continue favoring accommodative monetary policies. To do so would risk allowing higher inflation expectations to become ingrained in the American psyche; and once this occurs, it becomes much more difficult and costly to unravel. The second reason is that public opinion implicitly supports tighter monetary policy, as most Americans appear much more frightened of persistent inflation than increased pressure on labor markets. The final reason is that the Fed leaders themselves are unlikely to dismiss the looming threat to their own legacies; and allowing the United States to repeat the Great Inflation of 1968-1982 would leave an indelible stain.

In combination, these conditions support the thesis that the Federal Reserve will tighten monetary policy aggressively until inflation is decisively contained. In addition, if history is a guide, it seems more likely than not that the Federal Reserve will overshoot. Considering this possibility, investors would be wise to mentally prepare for heightened volatility, which may include large price declines in risk assets over the next year or two. Yet, at the same time, they must resist the ever-present temptation to time the market. For those tempted by such speculation, perhaps the timeless words of Former Federal Reserve Chairman Paul Volcker will prove helpful. In his memoirs, Volcker recounted the futility of predicting economic events with precision, stating: “There is a prudent maxim of the economic forecaster’s trade that is too often ignored: Pick a number or pick a date, but never both.”

Suggested Citation

Higgins, Mark, The Federal Reserve’s Dovish Days are Suspended: Investors Should Brace Hard for the Hawk (February 5, 2022). Available at SSRN: https://ssrn.com/abstract=4027547 or http://dx.doi.org/10.2139/ssrn.4027547

Mark Higgins (Contact Author)

Enlightened Investor, LLC ( email )

United States

HOME PAGE: http://www.enlightenedinvestor.com

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