The Limits of Federal Reserve Power

It’s been a light week for economic data, with the exception of better than expected January CPI inflation data last Friday.  Low inflation is positive, but the main market driver continues to the "AIpocalypse" of software, financial services, and other sectors where AI is seen to have the biggest disruptions.¹  

With the new year well underway, and a Fed Chair handover just ahead on May 15, market analysts, economists, and prognosticators are thinking about the path of short term interest rates for the remainder of 2026, and whether that path will change significantly under Kevin Warsh, who was appointed by President Trump, who has repeatedly called for lower interest rates.

However, what if the Fed has much less ability to influence the economy than most people think?  

The Limits of Federal Reserve Power: Interest Rates, Inflation, and Growth

A central question in modern monetary policy is the extent to which the Federal Reserve can effectively control interest rates, inflation, and economic growth. While the Fed is often viewed as the primary lever for steering the economy, an analysis of market data and recent academic literature suggests its power is significantly more constrained than popularly believed.

Interest Rates and Mean Reversion:

The conventional wisdom holds that the Fed raises interest rates to tighten credit and lowers them to stimulate borrowing. However, data regarding the yield spread—the difference between long-term bond yields and the short-term Federal Funds rate—suggests a different reality. Economist David Ranson of HCWE plots data back to 1955 that illustrates major Fed policy initiatives (hikes or cuts exceeding 200 basis points), that the yield spread inevitably reverts to its long-term average.²

This phenomenon indicates that the Fed’s ability to alter the shape of the yield curve is temporary. While the Fed can mechanically influence the short-term Federal Funds rate, market forces dominate the long end of the curve. Consequently, aggressive rate hikes or cuts create temporary deviations, but the market eventually overrides these policy attempts, pulling the spread back to its natural equilibrium.³ Furthermore, since the 2008 crisis, the Fed has often found itself constrained by the "zero lower bound," limiting its ability to use conventional rate cuts to stimulate the economy.⁴

The Inflation Dilemma:

The Fed's influence on inflation is similarly debated. Despite massive expansions of the monetary base (Quantitative Easing) following the 2008 financial crisis, inflation remained persistently low, often undershooting the Fed's 2% target.⁵ Critics argue that the Fed lacks the practical means to control the value of the dollar compared to the U.S. Treasury, and that inflation is driven more by the velocity of money—which has declined—than the sheer quantity of reserves created.⁶

The Fed has a Commitment Problem:

Inherent in the Fed's dual mandate (targeting both price stability and maximum employment) creates a problem of committing both mandates. Adopting a dual mandate has been shown to result in systematically higher inflation—roughly eight percentage points higher than inflation-only mandates—without delivering statistically significant long-term employment gains.⁷ This suggests that broadening the central bank's focus may weaken its ability to deliver on price stability while failing to achieve its employment goals.⁸

Economic Growth and Asymmetric Power:

Empirical evidence suggests that monetary policy is asymmetric: it is more effective at slowing an overheating economy than stimulating a weak one. This concept, often described as "pushing on a string," is supported by findings that monetary contractions have powerful effects, while expansionary shocks (rate cuts) have negligible impacts on output during recessions.⁹

Historical data further indicates an inverse correlation between government stimulus and economic performance. Recoveries in GDP often appear proportionate to the depth of the preceding setback (such as the reopening following COVID-19 lockdowns) rather than the size of the monetary or fiscal stimulus package.10 Consequently, the Fed's attempts to engineer growth through zero-interest-rate policies may result in the mispricing of credit and the misallocation of resources rather than genuine economic expansion.¹¹

While the Federal Reserve plays a critical role in stabilizing financial markets during panics, its ability to fine-tune the real economy is limited. Market forces tend to neutralize the Fed’s impact on interest rate spreads over time, and the transmission of monetary policy is weak during recessions. Ultimately, the expectation that the Fed can independently generate growth or precisely control inflation may overstate the institution's actual leverage over a complex global economy.¹²  

Footnotes

1. Bloomberg News, 2/13/25, US Annual Core Inflation Falls to Slowest Since 2021

2. David Ranson, TC-1225-V1-D4.pdf, Slide 10, "The Spread between the Long and Short Ends of the Yield Curve Following a Fed Initiative." [Source Document provided in chat context].

3. Ibid.

4. Marc Labonte, "Federal Reserve: Unconventional Monetary Policy Options," Congressional Research Service, R42962, February 6, 2014. https://crsreports.congress.gov/product/pdf/R/R42962

5. Simon Constable, "The Fed’s Policy Shift to Let Inflation Rip Higher Is Deeply Flawed," The Daily Economy, American Institute for Economic Research, September 8, 2020. https://www.aier.org/article/the-feds-policy-shift-to-let-inflation-rip-higher-is-deeply-flawed/

6. Ibid.

7. Ana Carolina Garriga and Cesar M. Rodriguez, "Balancing Act or Policy Pitfall? The Effects of Central Bank Dual Mandates," Munich Personal RePEc Archive, MPRA Paper No. 125925, August 22, 2025. https://mpra.ub.uni-muenchen.de/125925/

8. Ibid.

9. Silvana Tenreyro and Gregory Thwaites, "Pushing on a string: US monetary policy is less powerful in recessions," American Economic Journal: Macroeconomics, Vol. 8, No. 4, 2016. https://www.aeaweb.org/articles?id=10.1257/mac.20150009

10. R. David Ranson, "Does Government 'Stimulus' Really Stimulate?" Independent Institute, March 30, 2021. https://www.independent.org/wp-content/uploads/article/2021/03/2021_03_30_stimulus_ranson.pdf

11. R. David Ranson, "Why the Fed’s Monetary Policy Has Been a Failure," Cato Journal, Vol. 34, No. 2, Spring/Summer 2014. https://ciaotest.cc.columbia.edu/journals/cato/v34i2/f_0031481_25529.pdf

12. Narayana Kocherlakota, "Rules versus Discretion: A Reconsideration," Brookings Papers on Economic Activity, Fall 2016. https://www.brookings.edu/wp-content/uploads/2016/09/kocherlakotatextfall16bpea.pdf

Researched and compiled with the assistance of Grok and NotebookLM. This newsletter represents our opined general assessment of the market environment at a specific time and is not intended to be a forecast or guarantee of future performance or results. The opinions and statements expressed are intended for information purposes only, and does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities or investment strategies to any person in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. This material may contain estimates and forward-looking statements, which may include forecasts and do not represent a guarantee of future performance. This information is not intended to be complete or exhaustive and no representations or warranties, either express or implied, are made regarding the accuracy or completeness of the information contained herein. The opinions expressed are as of February 17, 2026, and are subject to change without notice. Investing involves risks. Past performance is not a reliable indicator of current or future results, and index returns do not account for fees. It is not possible to invest directly in an index.

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