During 1994, the Fed unexpectedly increased interest rates, and this helped to preserve price stability and high employment for many more years. But according to the FT, 1994 is a cautionary tale:
The current Fed approach to communicating with market participants is its way of dealing with what could be called the 1994 problem. In February of that year, the US central bank caught investors around the world off guard when it raised rates for the first time in five years — by 0.25 percentage points to 3.25 per cent.
US bond prices fell and the S&P 500 index dropped 9 per cent over the next month. Amid the ensuing turmoil, California’s Orange County, which had used public money to make complex bets that interest rates would remain low, filed for bankruptcy.
In the years that have followed, the US central bank has taken pains to avoid surprising the markets, which makes sense. Dislocations of the 1994 kind obviously complicate the Fed’s mission to promote price stability and maximum sustainable employment.
That final sentence makes no sense. If interest rates are volatile but inflation and employment are stable, that counts as a big success, doesn’t it? Why would the Fed prefer stable interest rates to a stable economy? Why would “dislocations” complicate Fed policy? I’m an Orange County resident, and even I couldn’t care less about their bankruptcy.
Perhaps the Fed avoided an unexpected rise in rates late last year due to fear of destabilizing the financial markets. If so, then the Fed’s desire to avoid surprising the markets has produced a very unstable economy, with an increased risk of recession in 2023.
I don’t want to make too big a deal of the Fed’s interest rate policy, which is not the biggest problem at the moment. The main problem is the Fed’s abandonment of FAIT. That’s the primary cause of the current high inflation. The Fed has lost credibility.