UBS highlights 3 Fed mistakes since 2021 and their impact on the economy.

UBS highlights 3 Fed mistakes since 2021 and their impact on the economy.

The Federal Reserve’s Three Big Mistakes: Impact on the Economy and a Solution


The Federal Reserve, according to UBS Global Wealth Management’s chief economist, Paul Donovan, has done a lousy job navigating the surge in inflation over the past two years. Donovan highlights three key mistakes made by the Fed since inflation broke out that will have a significant impact on the broader economy.

Fed chairman Jerome Powell’s recent decision to hike interest rates further reinforces the repercussions of these mistakes. While the benchmark rate has been raised by 25 basis points to a range of 5.25% – 5.50%, representing a 22-year high in the Fed funds rate, UBS suggests that this rate hike will likely have to be reversed in the near future. Donovan argues that the damage caused by the recent tightening policy has yet to fully take effect in the US economy. Today’s additional rate hike from the Fed uncovers the root causes of what has gone wrong.

Mistake 1: Failure to Communicate

According to Donovan, one of the major blunders made by the Fed was its failure to effectively communicate changes in inflation dynamics. The Fed initially described the inflation in 2021 as transitory, which was an accurate assessment. However, as inflation shifted due to the wartime energy shock, the Fed failed to communicate the changes properly, resulting in a hit to its reputation. Donovan suggests that if the Fed had done a better job of explaining the evolution of inflation, it might have been less paranoid about damaging its reputation. Good “spin” is crucial in maintaining credibility.

Mistake 2: June 2022 Policy Errors

The Fed’s decision to focus on consumer price data, which relies heavily on factors like owners equivalent rent, instead of considering a broader set of measures, was another policy error highlighted by Donovan. This shift led to the abandonment of forward guidance and eroded the credibility that had been built up over the years. Furthermore, the decision was made based on high inflation expectations, which were later revised down within days of the policy announcement. Donovan raises concerns about how some policymakers seem to be treating economic data as trustworthy, without acknowledging the declining quality of these figures. A more sensible approach to the diminishing reliability of economic data could have prevented the repeated tightening strategy.

Mistake 3: Failure to Push Back on “Greedflation”

The Fed’s delay in addressing the profit-led inflation episode that began in late 2021 is viewed as a critical misstep by Donovan. He argues that Fed Chair Powell has not thoroughly analyzed the inflation episode and tends to view it as a single, homogeneous event, rather than recognizing the three distinct problems it presents, each requiring unique solutions. According to Donovan, these three drivers of inflation over the past year have been buoyant consumer spending, the war in Ukraine, and corporate greed.

Impact on the Economy and a Solution for the Fed

While the US economy still appears to be on track for a soft landing, Donovan emphasizes that the Fed’s over-tightening policies will unnecessarily harm low-income groups and inject unnecessary uncertainty and volatility into financial markets. He believes that the lessons from this tightening cycle are clear:

  1. Improving communication is crucial, not just to the general public, who may not fully grasp the nuances of the Fed’s actions, but especially to the markets.
  2. The Fed needs to take a more critical view of the data it receives and acknowledge the possibility of errors or inaccuracies.
  3. It would be beneficial to have an economist leading the organization, someone who can provide an expert understanding of economic dynamics and make informed decisions.

By taking these steps, the Fed can regain credibility, enhance its ability to manage inflation, and avoid repeating the mistakes of the past.