The Fed's Massive 1937 Mistake: Is It Happening Again?

In a new report, MKM Partners Chief Economist Michael Darda discussed his case for the Federal Reserve to remain dovish until the United States generates the inflation and wage growth numbers that the Fed has targeted.

Darda believes that the biggest mistake the Fed could make is to raise rates too early, and he argued that the 2014 taper and the end of asset purchases in 2015 were the true beginning of this tightening cycle.

Elusive 2 Percent Inflation

Darda pointed out that the Fed’s own forecasts don’t currently project a return to its 2.0 percent inflation target until 2018. At the same time, the 2014 taper and the end of asset purchases this year have put an end to monetary base growth, which typically indicates slower NGDP growth ahead.

“Inflation is unlikely to explode upward if NGDP growth starts to trend closer to 3 percent than the 4 percent average that has characterized most of the recovery,” Darda explained.

Fed Criticism

While the Fed has been taking some heat from hawkish onlookers for its decision not to raise rates in September, Darda believes that a better criticism is why it was ever considering a September rate hike to begin with.

He feels that the Fed is likely predicting that below 5.0 percent unemployment means that wage growth and inflation growth cannot be far behind.

These assumptions are based on the Fed’s likely use of the Phillips Curve model, which Darda believes is a “highly flawed model.”

Avoiding A 1937 Scenario

Darda believes that the current state of the U.S. economy is similar in many ways to 1937.

Back then, the Fed tightened rates based on projections and estimates rather than actual numbers; the economy ultimately proved to be too weak to handle the tightening.