What Does it Mean When the Fed is ‘Behind the Curve?’

By Tony Jacoby, CFA – Portfolio Manager, Shelton Capital Management

For more than a year, inflation has steadily increased in the U.S. while policy makers and investment gurus on TV have been throwing around terms such as ‘transitory inflation,’ ‘supply shock’ and ‘demand crush’ like Nolan Ryan’s knuckles to the top of Robin Ventura’s head.

While it was difficult to ignore prices at the pump and grocery store rising through the summer of 2021, it wasn’t until November, at his re-confirmation hearing before Congress, that Fed chair Jerome Powell stated it was probably a good time to retire the word ‘transitory.’ The response from TV pundits alike shifted to debating whether or not the Fed was ‘behind the curve.’

If you’re scratching your head at these terms and wondering what they mean for your job security or investment portfolios, you’re not alone. Policy makers are lifelong academics from the most elite universities in the world, communicating complicated and dry policy matters to insiders with decades of industry experience. The average American is excused from hanging on every word of a press conference about monetary policy when they must pick up dinner on the way home after their kids’ soccer practice.

So, what does ‘behind the curve’ mean in terms that the average American can understand? In April 2022, James Bullard, President of the Federal Reserve Bank of St. Louis and voting member of the Federal Open Market Committee (FOMC), gave presentations at Princeton University and University of Missouri regarding the Fed’s own measure of being ‘behind the curve.’ He came up with two interpretations.

Interpretation One:

Academic Definition: “Standard Taylor-type monetary policy rules, even if based on a minimum interpretation of the persistent component of inflation, still recommend substantial increases in the policy rate.”

Translation: A little inflation is good (~2%) because it represents growth of the economy. In order to target good inflation, a policy interest rate is calculated based on theory with lots of inputs and estimates. If the calculated interest rate is a lot higher than the current interest rate, then the Fed is ‘behind the curve.’

The Fed has blunt tools which it must use carefully. One tool, raising or lowering base interest rates, is probably the most known to the average American. The Federal Reserve has tools which allow it to manage the Fed Funds Rate, the interest rate that banks charge each other for lending excess reserves in a bank’s Federal Reserve account. The Fed Funds rate, in turn, impacts the interest rates charged for bank loans, mortgages, credit cards, etc. A rate increase, in theory, should ripple through the lending system and start to slow consumer and business demand for products and services, eventually reining in inflation.

That ripple could also impact companies that had expansion plans when borrowing was cheap and may now be looking to tighten the belt in the form of layoffs or salary cuts, especially if rates are raised too quickly or unexpectedly for the company to pivot nimbly. An over-correction by a Fed that is ‘behind the curve’ has the potential to crush demand, the labor market, or ultimately trigger a recession if they are too heavy handed.

Interpretation Two:

Academic Definition: “Credible forward guidance means market interest rates have increased substantially in advance of tangible Fed action.”

Translation: The Fed hasn’t done enough yet to target good inflation. But based on some good faith and a track record of acting to moderate inflation since the late 70’s, the Fed believes the market will correct itself ahead of further action. If the Fed didn’t promise to do enough and rates are still below what is needed for good inflation, then the Fed is ‘behind the curve.’

Prior to 2006, when Ben Bernanke began his reign at the Fed, the previous Fed chair, Alan Greenspan, had a reputation for engaging in what was known as ‘Fed Speak,’ which was a vague way of communicating to the public without really saying anything at all. The intent was to keep their cards close to their chest to prevent markets from making bets based on the intentions of policy makers. However, the downside was that unknown plans could result in wild market swings when the Fed did something unexpected. Fast forward to the post-Greenspan era, the Fed representatives began to be more transparent with their intentions ahead of acting in hopes this would prevent large market fluctuations. Which also meant policy makers had to be very deliberate with their words and actions to maintain credibility.

What Does This All Mean?

The policy makers at the Fed are not in a desirable position. The Fed has a dual mandate of maximizing employment and maintaining price (inflation) stability, which could be seen as opposing goals right now. In a best-case scenario, there is a ‘soft landing’ where inflation gets under control without driving down demand enough to trigger a recession. However, if inflation does not reverse course in response to the actions already taken by the Fed or the expected rate hikes that the Fed has already committed to, then companies may start looking at cost-cutting measures. What will happen next is anyone’s guess, but hopefully the mere threat of a recession is sufficient to curb spending enough to slow the rate of inflation.

This article was originally posted on Nasdaq.com.

About Shelton Capital Management

Shelton Capital Management is a multi-strategy asset manager with fund administration and digital marketing expertise. With a determined focus on growth, Shelton Capital is active in acquisitions and fund consolidations. Shelton Capital Management has expertise in mutual fund and separately managed account advisor mergers and has completed seven transactions with the goal of improving the financial and economic performance of partner firms. Shelton Capital manages over $3.2 billion of assets as of 6/30/22. For additional information, visit https://sheltoncap.com.

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