Why the Fed Caves

"Well, we're now so levered up that once it gets outside these limits, it gets ugly in a hurry."
--Will Emerson (Margin Call)

Chart below shows the Fed Funds target since 1992. The low periods correspond to recessions (~1992, 2002, 2008). Note the lower lows and lower highs--the technical definition of a downtrend.

This helps portray the Fed's predicament. Each time we have a recession, the Fed lowers rates below market, prompting more borrowing than would otherwise occur. In natural market cycles not subject to central bank intervention, just the opposite should occur. Debt should fall during a recession as bad loans get extinguished, interest rates rise, and saving commences.

In unnatural market cycles, with Fed policies that force rates lower, we get more debt and leverage. And, by definition, less savings.

This leaves the system weaker coming out of downturns rather than stronger. Thanks to central bank policies, the system always exits a recession more levered up than before.

Thus, attempts by central banks to 'normalize' rates back to levels of previous expansions are destined to fail. Why? Because the greater the leverage in the system, the less tolerant the system is to rising interest rates and falling asset prices used as collateral against the debt.

Stated differently, the collective balance sheet, being more leveraged, is more susceptible to insolvency should rates rise and asset prices fall.

This is why the Fed always caves and turns dovish earlier in the present cycle compared to the previous cycle. With each passing cycle, the Fed paints itself (and the economy) farther into a corner that it cannot escape.