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This market is a teenager who needs to be grounded

Karl W. Smith
Karl W. Smith • 4 min read
This market is a teenager who needs to be grounded
Photo: Bloomberg
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The US Federal Reserve is under pressure to stop raising interest rates lest it plunge the entire world into recession. This concern is not unfounded.

Nonetheless, the Fed must not be deterred from its task: Like a parent disciplining a difficult child, it knows what it has to do, even though it may not relish doing it.

This metaphor — how monetary policy is like parenting — is admittedly homespun but surprisingly useful. Let’s see how far we can take it.

First, about that concern over a recession: It is the very members of the Fed who are most worried about unemployment and the plight of the poor who should be most firm in their resolve to bring down inflation. This may seem contradictory. Economists (like myself) concerned about employment have typically been on the other side of the debate from those concerned about inflation.

But calling on the Fed to stop raising rates before it “breaks” the financial markets — or worse, the labour markets — is overly cautious. It risks exacerbating the pain it seeks to mitigate.

Here’s where the parenting metaphor comes in. The relationship between Fed policy and the financial markets in some ways mirrors that between a parent and a child. It’s not that the Fed always knows best. That type of deification — promoted by the likes of Alan Greenspan, among others — is unhealthy for both the markets and policymakers.

See also: Bank of England revives speculation of UK rate cut this summer

Rather, it’s that the Fed has the responsibility to constrain the ambitions of the financial markets. It doesn’t necessarily enjoy this responsibility, in the same way that a parent does not enjoy disciplining a child — and, as the child is, the markets are aware of this ambivalence and often try to exploit it.

Financial innovation and ubiquitous credit allow the creative spirit of entrepreneurialism to combine capital and labour in ingenious ways. Yet the financial markets have a tendency to take on more ambitious projects than the economy can handle. This can show up as excessive risk, as it did in the aughts, or as soaring inflation, as it is now.

In these cases the Fed must apply the restraint of tighter monetary policy and higher interest rates. In doing so it shuts down not just consumer spending, but new businesses and civic enterprises that might have taken advantage of both easy access to credit and a robust sales environment. There is no way to separate these effects.

See also: When, oh when, will the stock market be revived?

The simple fact is that tighter monetary policy leads to rising unemployment and lower productivity even as it brings down inflation. It is a blunt instrument that policymakers rightfully disdain. Many market participants know that the Fed disdains it — and some are willing to place bets that the bank will not have the nerve to go through with it.

They will continue to fund unsustainable levels of spending, even as entrepreneurs and small businesses are crushed by higher interest rates. This spending causes inflation to persist longer, requiring higher interest rates and more punishment.

This unfortunate equilibrium is akin to the teenager who constantly pushes the boundaries of what they can get away with, while the parent reluctantly doles out the minimum punishment without setting firm guidelines and sticking to them, come what may. Both parties suffer.

Likewise, if the Fed does not deliver enough tightening to bring inflation back on track to 2.5% — come what may — it risks entering into an unfortunate equilibrium with the financial markets. The Fed will always be promising to raise interest rates and keep them high, and the markets will always suspect that the Fed will lose its resolve.

Thus inflation will persist and the Fed will have to keep raising interest rates ever higher — or keep already-high rates ever longer — in an attempt to convince financial markets that it’s serious. This outcome is the most painful for entrepreneurs, small businesses and workers on the margin of employment. It should be avoided at all costs.

That’s why Fed governors and regional presidents who are most concerned about inflation must show that they’re serious about raising rates to at least to 4.5%, and further still if inflation persists. Come what may. – Bloomberg Opinion

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