Two major policy mistakes have been made by the Federal Reserve.

Being unaware that the foundation of the U.S. banking system had been eroded by complex mortgage securities that carried high credit ratings but turned out to be toxic during a broad housing downturn was the first thing that came to mind. The global financial crisis in 2008 was caused by the collapse of valuations in the U.S.

The final chapter of this saga is still to be written after a misreading of the strength of the labor market and persistence of price shocks caused the highest inflation rate in forty years. The worst year in financial markets since the 1930's was made possible by the policy error. The MarketWatch 50 list of the most influential people in markets has Federal Reserve Chairman Jay Powell on it.

The Fed has been criticized by critics. The worst inflation call in Fed history was made by Powell when he insisted that rising inflation wastransitory and would quickly diminish once the economy reopened more fully. Powell is similar to Arthur Burns, the former Fed chair, who was indecisive under intense political pressure, leading to the crushing inflation of the 1970s. When the Labor Department reported a 7.9% annual rise in consumer prices, Powell and the Fed were just wrapping up their injections of cash into financial markets.

If Powell is able to tame inflation without causing the US to go into a deep recession, he will be remembered. The debate about what signs the U.S. central bank ignores and why will continue for a long time.

The Federal Reserve doesn't know anything about soft landings.

The causes of the policy mistake are being debated. Powell has begun to chime in. The initial policy error was caused by four underlying causes. The Fed's new policy framework, Powell's distrust of forecasts, and the nature of the economy's perfect storm are included.

A new policy framework unveiled in August 2020

The Federal Reserve announced a monumental shift in August 2020. The U.S. central bank had been working on a new framework for monetary policy for more than a year before the Pandemic hit.

Powell said that the economy is constantly evolving. The Fed interest-rate committee has a plan for achieving its goals.

Powell didn't refer to the economic events of the early days of the Pandemic. The policy shift was designed for a world of low inflation that had dragged on for two decades.

It was hard to get inflation to 2% for 20 years. The framework assumed that the environment would persist, according to the former Boston Fed president.

After the bout with high inflation in the 1980s, the Fed decided not to raise interest rates until there was a strong labor market. The Fed wouldn't use the blunt tool of raising interest rates to increase borrowing costs for businesses and consumers in order to lower inflation.

The Phillip Curve models used by the Fed say that tight labor markets are a main driver of inflation.

Stephen Stanley, chief economist at Amherst Pierpont Stanley, a U.S. fixed income broker, was skeptical of the change. In an email to clients after the new framework was announced, Stanley said that Powell had concluded that inflation was a mystery to the Fed, and since it has no ability to accurately predict inflation, it must react to it after the results are in.

If inflation occurs with long and variable lags, then a reactive policy will always be behind the curve. The inflation genie will be out of the bottle when the Fed realized that it was too easy. The approach that got the Fed in so much trouble was this one.

The new framework is believed to be the cause of the current inflation outbreak.

The framework caused the committee to delay actions that it could have taken more aggressively.


The chief economist at Wrightson ICAP said that Powell and his collegauges didn't keep up with the changing economic outlook.

They were determined not to overreact to high inflation.

Powell was a partner at the Carlyle Group and was very skeptical of economic models and forecasts.

A career in private equity will make you cautious.

It was hard to get inflation to 2% for 20 years. The framework assumed that the environment would continue.

— Eric Rosengren, former Boston Fed president

The Powell Fed used to rely on forecasts, but now uses an outcome-based reaction function. The Fed wanted to see the whites of the eyes when it came to inflation.

The chief economist at the Bank Policy Institute is not fond of using current levels to make policy.

Nelson wrote in a summer email that the Fed should not look around. It's the same as driving a vehicle. You need to be aware of what's going on for a smooth ride. You end up having to slam on the brakes or accelerate if you just look at your surroundings.

Forward guidance turns into straitjacket for the Fed

There is a mistake that Fed officials make. Financial markets in 2020 will receive two pieces of forward guidance.

In the wake of the financial crisis in 2008, participants in the bond market began to think that the Fed would raise interest rates. The Fed gave the market guidance that it was not changing course because it didn't want long-term bond yields to rise. Interest rates were low because of this. The Fed didn't raise its interest rate until next year.

The Fed has been buying Treasurys and mortgage-backed securities in order to support the markets and the economy since the beginning of the Pandemic.

Powell and the Fed wanted to lay out the criteria needed to slow down and end the bond purchases as part of their forward guidance.

The market believed that ending bond purchases was a precondition to a rate hike. The market didn't think the Fed would raise rates if it was buying assets. The Fed waited two years between ending purchases and raising rates.

In September 2020, the rate-hike guidance came first. The Fed said it wouldn't raise its benchmark rate until labor-market conditions are in line with the committee's assessment of maximum employment and inflation.

In December 2020, the Fed gave forward guidance that it would keep buying bonds at a rate of $120 billion a month until further progress is made towards the Committee's maximum employment and price stability goals.

Financial-market participants took it as a sign that the Fed wouldn't raise rates until at least 2022. There was talk of bonds being bought for six months. Inflation pressures increased as the day went on.

In a speech last year, Christopher Waller, a Fed governor, said that the economy evolved quickly.

The guidance the Fed had issued might not have allowed enough flexibility for Powell and the other 11 voting members of the monetary-policy-setting Federal Open Market Committee.

Powell said that the Fed wanted to make a strong statement that it would get inflation back to 2%.

That has not changed the situation. Powell admitted that he wouldn't do that again. The lesson could be to leave a little more flexibility in the guidance.

Powell was unsure if it mattered in the end. I don't think it did. I don't think it would matter if we'd been raising rates earlier.

The Fed stopped buying bonds just days before it raised its interest rate. Powell and other Fed officials have said that forward guidance needs to be improved.

The perfect storm

The perfect storm that no one could have predicted was the reason why the Fed made a mistake.

Not seeing all the inflationary forces come together was the main issue. This was a great storm. Mark Gertler is a professor of economics at New York University and has co-authored papers with the former Fed chairman.

The rapid economic recovery from the COVID-19 lockdowns led to a burst in demand, but it was also complicated by supply chain disruptions related to the Pandemic. The war in Ukraine was one of the factors that pushed up oil prices. Wages increased due to labor market shortages caused by the slow return to work, retirements and resignations from unpleasant work during the Pandemic.

Gertler said that the forces make sense, but economists didn't anticipate them all.

There was a long history of low inflation in the decade before the Pandemic. The Fed had been trying to push inflation to 2%. There were serious questions about whether central banks could create inflation. The fiscal and monetary policies that were put in place after the financial crisis did not raise consumer prices above 2%. Gertler said that they didn't see this coming.

The National Bureau of Economic Research made a mistake when they called the two-month downturn at the start of the Pandemic in March-April 2020 a recession. He said that the recession label caused the Fed and Congress to pour onStimulus that wasn't needed.

The recession didn't start in February but in March according to the NBER.

Is the US in a recession? Here is why.

Lawmakers passed several massive fiscal relief packages and the central bank held interest rates at zero for too long because they were worried about a depression.

Financial storms are part of the territory for the Fed. The central bank made a lot of mistakes in 2008. The Fed puts in place capital requirements for the largest banks to make sure they have enough capital to weather a severe recession.

Powell and other Fed officials don't think it's a good time to review the 2020 policy framework and the Fed's recent error on inflation

The framework can't be blamed. There was a sudden burst of inflation. The reaction to it was what Powell said. When the Fed says it will review the policy, the discussion may have to wait.