Recent action by the Federal Reserve to lower interest rates, end quantitative tightening and promise more interest rate cuts in the future has been welcomed by markets. Stocks, bonds and gold have all been climbing based on this newfound easing by the Fed.

This stands in stark contrast to the situation in December 2018 when the Fed completed the last of four rate hikes that year and stock markets staged the Christmas Eve Massacre, which topped off a full-scale market correction from Oct. 1–Dec. 24, 2018. The Fed (and markets) have been recovering from the Fed overtightening ever since. But with a weak economy and declining markets in late 2018, why was the Fed tightening in the first place?

The Fed usually tightens when the economy is overheating and inflation or asset bubbles are expanding dangerously. None of that was the case in late 2018. The answer is that the Fed was raising rates and reducing its balance sheet (so-called “quantitative tightening,” or QT) in order to prepare for the next recession.

It usually takes five percentage points of rate cuts to pull the U.S. out of a recession. The Fed was trying to get rates up from about 2% to closer to 5% so they could cut them as much as needed in a new recession. But they failed.

The market reaction and a slowing economy caused the Fed to reverse course and engage in easing. That’s good for markets but terrible in terms of getting ready for the next recession.

The Fed’s conundrum between rate hikes to prepare for recession and rate cuts to avoid recession is described in this article. While markets have responded well to the Fed’s new easing policies, the danger that the Fed is unprepared for a new recession has only grown.

If a recession hit now, the Fed would cut rates by another 2% in stages, but then they would be at the zero bound and out of bullets. Beyond that, the Fed’s only tools are negative rates, more QE, a higher inflation target or forward guidance guaranteeing no rate hikes without further notice.

This is not the result of bad leadership by Jay Powell. It’s the result of 10 years of bad leadership by Ben Bernanke and Janet Yellen that gave us the zero rate policy from 2008–2015.

It would have been helpful to raise rates in 2010 or 2011 when the economy was in the early stages of its expansion. Now it’s too late and the Bernanke-Yellen science experiment has been dumped in Jay Powell’s lap.

The only way out is for the Fed to guarantee inflation, “whatever it takes.” The best way to profit from that promise is with gold.

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