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3 Reasons the Federal Reserve Can't Prevent a Recession

By Sean Williams – Updated Aug 8, 2018 at 8:56AM

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Despite numerous tools at its disposal, another recession is inevitable.

Since the end of World War II, the United States has undergone 12 separate periods of economic expansion. In total, 750 of the 873 months since October 1945 have been spent with the U.S. economy growing. That's a pretty good record, and a key reason stock investors tend to do very well for themselves over the long run.

Currently, the U.S. economy is on track to make history. Following the steepest recession this country has seen since the Great Depression, the ongoing economic expansion, which began in June 2009, is the second longest on record, at more than 108 months. Should this expansion make it to at least July 2019, it would surpass the period leading up to the dot-com boom that lasted 120 months (March 1991-March 2001) as the longest ever. 

The facade of the Federal Reserve building in Washington, D.C.

Image source: Getty Images.

The Federal Reserve has played a key role in this ongoing economic expansion

Though novels could be written about the many factors that have aided in the current economic expansion, our nation's central bank, the Federal Reserve, certainly deserves some credit.

The Fed and its voting members are responsible for setting the nation's monetary policy to promote economic growth, stabilize the price of goods and services, and moderate long-term interest rates. Though the Fed doesn't specifically set the interest rate you pay on say your mortgage or credit card, its benchmark fed funds target rate influences what banks pay when borrowing from each other in the short term (usually overnight). This, in turn, works its way down the line, influencing interest rates on credit cards, variable-rate loans, and even mortgages. 

Sensing how fragile the U.S. financial system was nearly a decade ago, as well as how leery businesses and consumers were of spending their money, the Fed undertook three rounds of quantitative easing designed to spur economic growth. Between 2010 and 2013, the Fed purchased mortgage-backed securities and Treasury bonds in an effort to spur inflation and growth. Many years later, it would appear their actions proved effective. 

Sorry, folks, but the Fed can't prevent recessions

Yet for as strong as this expansion feels -- U.S. GDP growth hit 4.1% in the second quarter, a nearly four-year high -- another recession is inevitable in the future. Despite the many tools at its disposal, there are three reasons the Fed can't prevent recessions from rearing their head.

A magnifying glass lying atop the market data in a financial newspaper.

Image source: Getty Images.

1. The Fed is reliant on backward-looking data

To begin with, the data is somewhat at fault. If the Fed had access to accurate, real-time data on job growth, inflation, GDP growth, spending and borrowing habits, money supply, saving rates, trade surpluses and deficits, manufacturing data, unemployment claims, and so on, it could make actionable decisions with little lag time. But that's not how things work right now.

For example, inflation data released by the Bureau of Labor Statistics from the previous month takes more than a week to compile.

By a similar token, quarterly GDP data goes through an initial estimate, a second revision, and then a final figure. This final data point doesn't become official until nearly three months after the previous quarter has ended.

The problem with backward-looking data is it leaves the Fed to be reactive to lagging indicators rather than proactive to real-time data. It's hard to avoid economic issues when you're making decisions based on potentially stale data.

A press at the U.S. mint printing hundred dollar bills.

Image source: Getty Images.

2. Emotions and hubris can play a role

Second, it's important to recognize that voting members of the Federal Reserve are human, and therefore fallible.

Make no mistake about it: Members who serve on the Fed are astute, and they understand most everything there is to know about economics, as derived from a textbook. But this doesn't mean they're always correct.

Back in 2014, Forbes contributor Bill Conerly examined Federal Reserve meeting minutes for clues as to what led to the Great Recession. Conerly's key finding was that Fed hubris got in the way. Members of the Fed were so certain that their assessment of the U.S. economy was correct that they were blinded from seeing a number of potential warning signs. Yes, investors and banking leaders were at fault, too, for overestimating their knowledge of risk and economics, but this is nevertheless a perfect example of fallibility coming into play. 

What's more, the economy doesn't always act as the textbooks say it should. This means there is no concrete formula for success in approaching monetary policy actions.

A person holding a binder that's labeled with the words, Tax Reform.

Image source: Getty Images.

3. The Fed has no control over fiscal policy

The third factor is that the Federal Reserve has no control over fiscal policy. Fiscal policy refers to the federal government's use of tax policy and spending to influence the economy.

Now, don't get me wrong. The Fed does take into account federal tax and spending actions when formulating its own monetary policy. However, it often takes many months, if not years, before fiscal policy begins to have an impact on the U.S. economy. This makes it difficult for the Fed to incorporate fiscal policy impact estimates into its models. And even when tangible effects can be recognized, as noted in point one, the data reporting will lag.

Ultimately, I believe the Fed has done a pretty good job of stimulating growth without sending inflation through the roof over the past decade. But no matter what the nation's central bank does, policy-wise, another recession is inevitable.

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