Cornered

There's a storm on the loose

Sirens in my head

Wrapped up in silend

All circuits are dead
--Golden Earring

In addition to providing more perspective on the Fed's dilemma (recently discussed on these pages here, here), this article includes some nice historical perspective on the Fed's approach to managing its monetary policy cycles. The Fed responds to crises by easing rates. Once trouble has passed, the Fed begins to raise rates. 

But because the easing phases invites more risk taking (and leverage), new troubles arise as rates go higher. Consequently, the Fed begins easing again. 

The important thing to understand is that the tightening phase generally does not return rates to their previous levels, resulting in a downward sloping long term trend as denoted by the red dotted line.

It should not be surprising that the secular downtrend in rates has been accompanied by higher asset prices. The graph below shows how the SPX has responded.

This is how the Fed has cornered itself. By failing to raise rates back to previous levels at the end of a monetary policy cycle, it has invited massive risk taking in financial assets. Nearly 40 years of this behavior has hyper financialized the system.

Now, with rates near zero, along with $trillions of balance sheet assets (also known as monetization) to keep the wheels on the wagon with rates at the 'zero bound' for the past decade+, the Fed will find it difficult to engage in any substantial tightening of monetary policy (necessary to fight inflation) without tanking financial markets.

Inflation or asset prices? The answer seems obvious.