Soft Landing?

We wrote last week about the soft landing that markets now seem to expect. If the US does have a soft landing it would be because the Federal Reserve tightened enough to slow inflation, but not enough to throw the economy into recession.

In our opinion, Fed policy should not be measured using interest rates alone. The Fed held the federal funds rate at 0% from 2008 to 2015 without inflation. During COVID, the Fed held the funds rate at zero for just two years. If seven years didn’t cause inflation, how did two years?

The answer to that question is that following the financial crisis, the Fed shifted to an “abundant reserve” monetary policy and held rates at zero, but increased capital requirements and liquidity rules by enough to keep the M2 money supply in check.

During COVID, the Fed expanded reserves through Quantitative Easing again but relaxed liquidity rules; using banks to distribute pandemic loans and hand out unemployment checks. As a result, M2 peaked at 27% year-over-year growth in February 2021. This is why inflation accelerated, right on time to prove Milton Friedman correct again.

Looking at the two things the Fed can control – interest rates and the growth rate of the money supply – there is a massive divergence. The funds rate is still below inflation. Looking at just rates, monetary policy is not yet tight.