The Fed and Goodhart's Law

Goodhart's law is:  When a measure becomes a target, it ceases to be a good measure.

The most common measure of when a recession is coming is the inverted yield curve.  I believe the Fed is now targeting this measure.

In the past when inflation got too high and the Fed needed to tighten monetary policy it would raise the Fed Funds rate.  This increases short term interest rates.  If short term rates were higher than long term (the dreaded "inverted yield curve"), it meant the Fed was tightening monetary policy and a recession would soon come.

So the Fed thinks that "inverted yield curve" is the cause of recessions.  So the plan now is to tighten monetary policy without inverting the yield curve, which they think will avoid the recession that usually comes from tightening.  The way they will do this is by leaving short term rates low and selling off bonds they bought during Quantitative Easing (QE).   This is being called Quantitative Tightening (QT).   When they sell bonds they will raise longer term interest rates.   If the Fed Funds and short term rates stay low, then the yield curve will not invert.  

Again, they think as long as they don't invert the yield curve they can get the mythical "soft landing" and avoid a recession.   They are wrong.   It is the monetary tightening that causes the recession, not the "inverted yield curve".

When rates are lowered it makes monthly payments on loans smaller so people and companies can buy things sooner.  We say "it brings demand forward".  Imagine someone can buy the $40,000 car of their dreams sooner if the Fed drops rates from 10% to 2% and so reduces the monthly payments.  The problem is that eventually this makes too much inflation and they have to let rates go back up.   This pushes demand backward.  Someone who was about to buy their dream car with a 2% loan now has to wait much longer when loans are at 10%.  The demand being pushed backward is the recession.   It is the rates going up that causes demand to be pushed backward, not the inverted yield curve.

Of course, if they don't tighten monetary policy they will get "run away inflation" and then hyperinflation.   So the Fed does need to tighten.  But doing it in a way that avoids the inverted yield curve will not avoid the pain of the tightening or result in a "soft landing". 

There is also a real risk that once people understand that bond prices will be falling as the Fed tries to dump bonds that everyone will "not fight the Fed" or "front run the Fed" and try to sell bonds before the Fed does.   For the last 40 years bond prices have generally gone up as interest rates went down.  Now with rates going up and bond prices going down we could see a rush to sell and indeed panic selling.   The saying is "the market takes the stairs up and the elevator down".  This is probably true for the bond market as well.  One should not expect bond holders to keep holding as bonds go down for years and years.  A bond crash makes more sense. 

So far the Fed has just recently stopped buying bonds and only raised Fed Funds by 0.25%.   But the markets anticipate the future and so have gone up significantly already.   The 30 year mortgage rate has gone from a low last year of 2.65% to 4.16%.

The 0.25% fed funds hike makes it seem like the Fed is not serious about fighting inflation.   But really it is probably just that they don't want to make the dreaded inverted yield curve.   We will see how serious they are when they start selling bonds.   If they let bond interest rates go way up, they are serious.  There is still some chance.

We will soon get the first recession without an inverted yield curve, because the Fed targeted this measure.  So the measure will cease to be a good measure.