The Federal Reserve: A Difficult Balancing Act: Part 1

Written by Larry Eppolito, MBA, CFP®

Greetings!

The Federal Reserve Bank (the "Fed") has been in the news a great deal lately. Depending on which newspaper you read, television channel you watch, podcast you listen to, or website you visit, you can find people arguing passionately that the Fed is doing exactly the right thing – or exactly the wrong thing.

This is a broad topic. So, I’m going to write this letter as a series of three letters. My first letter will re-establish a foundation in Fed basics –for those who need a refresher.

My second letter will highlight important (and interesting) history, which I believe is important context for today’s environment. And finally, my third letter will address what we know about the views and priorities of the Fed's new Chairman, Kevin Warsh.

Unfortunately, discussions about the Fed often become political. I think that's a mistake. As you know, I try very hard not to view issues through a Republican or Democrat lens. I try to understand the issues on their own merits and evaluate them as objectively as possible.

The Fed's job is difficult. In fact, it may be one of the most difficult jobs in government. Its decisions affect inflation, employment, interest rates, economic growth, innovation, financial markets, homebuyers, retirees, borrowers, and savers.

As with most important issues, I don’t believe there are perfect answers – only tradeoffs. With that in mind, I believe the following to be true.

The Federal Reserve Bank (The Fed)

The Fed is an independent government institution that has an enormous influence over economic activity.

The Fed has a dual mandate – to maintain full employment and to keep inflation under control. It sounds easy, but it has proven to be quite a task, as the economic “winds” regularly shift – and worse, there are many underlying forces acting as headwinds or tailwinds. Trying to understand what forces are shaping the economy – and how powerful those forces may be – is somewhat like trying to predict the weather, but much harder.

Before we continue, here are a few terms you've heard me use over the years, along with some commonly used by the financial media:

• Fuel for the "economic fire": Money and credit that help keep the economy growing.
• Monetary policy: The Federal Reserve's efforts to influence inflation, employment, and economic growth, primarily by changing interest rates.
• Monetary inflation: Inflation that can occur when money and credit available grow faster than the economy's ability to produce goods and services.
• Cyclical inflation: Temporary inflation caused by supply-and-demand imbalances, often in areas such as food or energy. These imbalances usually correct themselves over time, which is why this type of inflation is often called “transitory.”
• Fed tightening: The Fed raises interest rates to slow economic growth and reduce inflationary pressures.
• Fed easing (or accommodation): The Fed lowers interest rates to encourage borrowing, spending, and economic growth.
• Headwinds: Economic forces that slow growth.
• Tailwinds: Economic forces that help growth.

Interest Rates – The Fed’s Main Tool

The Fed's most important tool is its ability to influence interest rates. When the Fed wants to slow inflation, it generally pushes rates higher, making borrowing more expensive for consumers and businesses. When it wants to encourage economic growth and job creation, it generally pushes rates lower, making borrowing more affordable. They’re primarily able to do this by purchasing and selling government bonds, which influence short-term interest rates and, ultimately, borrowing costs throughout the economy.

Federal Open Market Committee: The Fed Chairman is Not a King

There are 12 voting members at each Federal Open Market Committee (FOMC) meeting who cast ballots to determine the direction of US monetary policy. The Fed Chairman summarizes the discussion and proposes a specific policy directive (e.g., to raise, lower, or hold interest rates) – but the Fed Chair only has one vote. It takes 7 votes to move policy. In practice, Fed Chairs try to build consensus, and major policy decisions are often approved by overwhelming margins rather than narrow 7-5 votes.

Doves and Hawks

The officials around the table are usually sorted into:

1. “Doves,” more worried about the job market and inclined to cut, and
2. “Hawks,” more worried about inflation and inclined to hike.

Larry, Why Not Just Cut Rates?

Generally, whoever occupies the White House tends to prefer lower interest rates. Lower rates can stimulate economic activity, support employment, and make people feel better about the economy in the near term. The challenge is that policies that help today can sometimes create problems tomorrow.

Depending on the strength of the various underlying economic winds, lower interest rates can:

• Help pull the economy out of a recession.
• Pour too much fuel into the economic fire, leading to rising inflation.

The decision to raise or lower interest rates is often an arm-wrestling match between competing economic forces. It’s not always obvious whether inflationary or deflationary pressures have the upper hand, nor how powerful those forces may be. This is what makes the Fed's job so difficult.

Larry, Haven't I Seen Mortgage Rates Rise Even After the Fed Has Lowered Short-Term Interest Rates?

Yes. We’ve seen this before.

Mortgage rates are driven primarily by longer-term interest rates, not directly by the Fed's short-term rate. If the Fed lowers short-term rates but mortgage rates rise, it's often because the bond market believes those lower rates could lead to higher inflation in the future.

The Bond Market Has a Vote

One of the most common misconceptions is that the Fed controls all interest rates.

The bond market has a vote, too. If investors believe the Fed is lowering short-term rates too much or too soon, they may demand higher yields on long-term bonds, pushing mortgage rates higher. This is one of the most misunderstood aspects of how interest rates work.

The Problem with Inflation

Inflation is more than just rising prices. Left unchecked, it can act like sand in the gears of the economy. Why? Because people and businesses make decisions today based on expectations about the future. For example, businesses may become reluctant to invest because future costs are less certain. Workers seek higher wages to keep up with rising prices. Consumers may accelerate purchases because they fear things will cost more in the future. Over time, these behaviors can make inflation increasingly difficult to control.

Once inflation becomes embedded in the economy, it can be very difficult to moderate without causing significant pain. It often hurts more to get rid of it than it does to avoid it.

The Self-Reinforcing Cycle

One reason inflation worries central bankers is that it can become self-reinforcing. Workers seek higher wages to offset rising prices. Businesses facing higher labor costs raise prices further. Those higher prices lead workers to seek additional wage increases. If this cycle becomes embedded in expectations, inflation can persist long after the original cause has disappeared. Breaking that cycle often requires higher interest rates, slower economic growth, and, unfortunately, higher unemployment.

Many economists believe this process played an important role in the inflationary spiral of the 1970s.

A Difficult Balancing Act

The challenge for the Federal Reserve is that its two goals – full employment and price stability – can sometimes conflict. Actions that help reduce inflation may weaken economic growth and increase unemployment. Actions that support employment and growth may create inflationary pressures. There is rarely a policy choice that benefits everyone at the same time.

This is why Fed officials spend so much time studying economic data, debating risks, and weighing tradeoffs. Their task is not simply to decide whether interest rates should be higher or lower. While elected officials often focus on current economic conditions, the Fed must try to determine how today's decisions may affect the economy months and even years into the future.

Understanding this balancing act is essential to making sense of today's debates surrounding the Federal Reserve. In the next letter, I’ll bring you back to the 1970’s – an important period in Fed history that continues to shape how policymakers think about inflation, unemployment, and interest rates today. That historical context helps explain why current Fed officials often appear cautious – and why some of the most consequential economic decisions are influenced by lessons learned decades ago.

In Summary:

• The Federal Reserve has one of the most difficult jobs in government: promoting maximum employment while keeping inflation under control.
• The Fed's primary tool is its ability to influence short-term interest rates. Higher rates generally slow economic activity; lower rates generally stimulate it.
• Monetary policy is set by the 12-member Federal Open Market Committee (FOMC), not by the Fed Chairman alone.
• The Fed's challenge is determining whether inflationary or deflationary forces are stronger – and how those forces may change over time.
• Inflation is more than rising prices. If it becomes embedded in expectations, it can become self-reinforcing and difficult to eliminate.
• The Fed influences short-term interest rates, but the bond market has a major influence on long-term interest rates. As a result, mortgage rates can sometimes move in the opposite direction of the Fed's short-term rate.
• There are rarely perfect answers in monetary policy – only tradeoffs.

As you know, we don't ask for referrals. However, if you know someone who might benefit from this letter, please feel free to share it with them. New relationships help keep our business young and vibrant, and we always appreciate the opportunity to be of assistance.

I know you’re as excited as me about Part 2! Stay tuned...

Best wishes,

Larry

6/29/2026

Larry Eppolito, MBA

Managing Partner, Eppolito, Carbone & Co.

Senior Financial Advisor, RJFS

CERTIFIED FINANCIAL PLANNER® Professional

Eppolito, Carbone & CO., LLC

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