Beyond its stated goals of employment and price stability, the Fed's recent aggressive asset purchases show its primary role is often to ensure smooth market functioning, making it dependent on market signals.
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After a decade of zero rates and QE post-2008, the financial system can no longer function without continuous stimulus. Attempts to tighten policy, as seen with the 2018 repo crisis, immediately cause breakdowns, forcing central banks to reverse course and indicating a permanent state of intervention.
The Fed's intervention in funding markets, while not officially labeled Quantitative Easing, directly helps the Treasury finance its debt, effectively monetizing it and providing critical liquidity to markets.
The common narrative of the Federal Reserve implementing Quantitative Tightening (QT) is misleading. The US has actually been injecting liquidity through less obvious channels. The real tightening may only be starting now as these methods are exhausted, signaling a significant, under-the-radar policy shift.
Despite conflicting inflation data, the Federal Reserve feels compelled to cut interest rates. With markets pricing in a 96% probability of a cut, failing to do so would trigger a significant stock market shock. This makes managing market expectations a primary driver of the policy decision, potentially overriding pure economic rationale.
The Fed's sudden dovish turn, despite admitting no new information was gathered, shows it reacts to immediate pressures like a weakening labor market rather than adhering to long-term inflation targets. This makes its forward guidance unreliable for investors.
In today's hyper-financialized economy, central banks no longer need to actually buy assets to stop a crisis. The mere announcement of their willingness to act, like the Fed's 2020 corporate bond facility, is enough to restore market confidence as traders front-run the intervention.
The Federal Reserve can tolerate inflation running above its 2% target as long as long-term inflation expectations remain anchored. This is the critical variable that gives them policy flexibility. The market's belief in the Fed's long-term credibility is what matters most.
The FOMC's recent rate cut marks the end of preemptive, "risk management" cuts designed to insure against potential future risks. Future policy changes will now be strictly reactive, depending on incoming economic data. This is a critical shift in the Fed's reaction function that changes the calculus for predicting future moves.
Jerome Powell's "driving in fog" analogy highlights the Fed's strategy of using uncertainty, such as a government shutdown delaying economic data, to justify slowing down policy changes like rate cuts. This gives them flexibility to guide markets later through speeches without being locked into a specific path.
The Fed is cutting rates despite strong growth and inflation, signaling a new policy goal: generating nominal GDP growth to de-lever the government's massive, wartime-level debt. This prioritizes servicing government debt over traditional inflation and employment mandates, effectively creating a third mandate.
