May 12, 2025
The economy in the 2020s has not been boring. We’ve had a pandemic and inflation already. Now we have a trade war, recession fears, maybe more inflation, and capital flying out of U.S. dollar assets.
In the past, the Federal Reserve would often step in to help. The famous “Greenspan put” was a much-used calming strategy. Recently we saw it during COVID and 2023’s bank failings.
But today, it’s hard to think Fed Chair Jerome Powell will step in as often or as aggressively. Even worse, the Fed’s tools might be ineffective.
That’s because even if we avoid recession, we could see stagflation, which is low growth combined with high inflation. That’s hard for the Fed to control. Cutting interest rates could spur inflation. Raising rates could hurt the economy and increase unemployment.
And we don’t know if either strategy will work.
Besides rates, Fed officials can also influence banks by adjusting reserve requirements and other rules. Still, all Fed tools relate to credit availability – making it easier or harder to get. For those with enough cash, interest rates don’t matter much.
So, Fed moves tend to hit the most leveraged parts of the economy – those with debt or those who need it. That means it matters who is in debt.
In the early 1990s, households were the primary debtors. Hangover from the 1980s’ real estate boom ended many construction and manufacturing jobs. A quick, mild recession was the result.
By 2001, banks had overtaken households. The Fed started tightening in mid-1999 to achieve a soft landing. But that failed, leading to a worse recession than the last one. Fortunately, it was quick.
Higher bank and household debt made the 2008 recession much worse. That excess debt got liquidated in what we now call the Great Recession.
However, today’s economy is different. The federal government, not households or businesses, is the biggest borrower.
Fed tools are aimed at those whose debt is already shrinking. If recession strikes and the Fed cuts rates, the stimulus effect on the private sector will be smaller than in previous recessions.
If the Fed tries to fight inflation, higher rates won’t suppress private sector demand as in the past because businesses and consumers aren’t as indebted as before. But higher rates will increase the government’s huge interest expense.
Time will tell how this plays out. But it’s becoming clearer that the Fed might not be able to fix things like in the past.