When the Federal Reserve sets its monetary policy, it is looking in the past more than it is looking in the future.  The Fed is trying to predict the future (and possibly change the future with its policies) by looking at statistics in the past.  Fed members will look at the price inflation rate, the unemployment rate, interest rates, the yield curve, and other factors in trying to predict what is on the horizon.

It has now been 10 years since the onset of the financial crisis.  The recession actually started officially in December 2007, but this was backdated.  We didn’t know we were in a recession in early 2008, or at least we don’t know officially.  The big dominos started to fall in September 2008, even though there had been certain events prior to that.  Housing was already falling from the peak of its bubble, and some lenders were already failing. But it wasn’t clear that we were in a major financial crisis and recession until around September 2008.

I recently looked at a chart of the federal funds rate.  This is the rate targeted by the Fed when it sets monetary policy.  It is the overnight lending rate for banks. Since late 2008, this rate has had less meaning because commercial banks have piled up massive amounts of excessive reserves. Therefore, the banks have little need to borrow overnight money to meet reserve requirements since they already easily meet reserve requirements.  The Fed controls the federal funds rate these days by paying interest on bank reserves.  This sets a floor below the federal funds rate.

Prior to 2009 though, the federal funds rate was largely controlled by the Fed’s buying and selling of assets – specifically U.S. Treasuries.  If the Fed wanted to lower the federal funds rate, it would buy U.S. government debt.  This would be done by essentially printing money, or its digital equivalent.  It was monetary inflation.

If the Fed wanted to raise the federal funds rate, it would do the opposite.  It would sell some of its U.S. Treasury debt.  It would reduce its balance sheet as necessary.  It would be deflationary in most cases, unless the rate was naturally rising without any Fed action.

The interesting thing, when looking at a chart of the history of the federal funds rate, is that the Fed was actually lowering the rate prior to the recession. It actually started to lower the target rate around September 2007, which was even before the official recession began.  The Fed kept dropping its rate throughout 2008.  Again, this was before the worst of everything became apparent in September 2008.  It was in December 2008 that the Fed finally lowered the target rate to near zero.

You can view the history of the targeted rate here.

The key point here is that the Fed correctly saw that there was economic weakness.  They tried to react to this by lowering the target rate, which would have also been mildly inflationary (although nothing compared to what was seen from late 2008 to 2014).

In other words, maybe Fed members saw a recession coming.  They would just never publicly say so.  They will use terms such as “lower growth” or “suboptimal conditions”, but they never say that they see a recession is coming. Otherwise, they would get the blame for “talking down the economy” when the recession actually does hit.

But the biggest takeaway from all of this is that the Fed was unable to prevent the biggest financial crisis and recession since the Great Depression, even though they likely saw something coming.  They were already lowering the federal funds rate.  They were loosening monetary policy, and it wasn’t enough to stop it.  At that point, the damage had already been done.  The loose policy from the Greenspan years was already over.  There was already massive malinvestment that needed to be corrected.  The market correction was going to take place regardless of what the Fed did at that point.  The damage had already been done.

I say this to make the point that it may not matter what the Fed does in the next couple of years. I’m not saying that what they do is completely irrelevant.  But when the misallocated resources are ready to be corrected by the market, the Fed isn’t going to be able to stop it.  They probably won’t even be able to delay it, barring some unlikely move towards hyperinflation.

In fact, if the Fed puts a halt to its balance sheet reduction, that will be a warning sign. If the Fed puts a halt to its rate hikes (of the federal funds rate), this will also be a warning sign. If the Fed actually starts lowering rates and/or starting monetary inflation again, then this is probably not going to prevent anything.  It will just be a further warning that things are likely to get bad really fast.

We’ve already got the yield curve as a warning indicator of a coming recession.  While the Fed’s monetary policy is not quite as reliable, it may add confirmation when the time comes.  The Fed was actually right to a certain degree in 2007, but it was helpless to correct its previous bad policies.