Published on 03-04-2025
The 2025 CFA Research Challenge Indianapolis welcomed Daniels School Distinguished Fellow Joe Tracy as featured speaker on February 21. As the featured speaker at the CFA Society Indianapolis event, Tracy offered valuable insights into the economic landscape, focusing on inflation drivers, monetary policy challenges and financial system stability. Based on his extensive experience, Tracy provided a comprehensive overview of the factors shaping the current economic environment and potential risks on the horizon.
Tracy pinpointed the primary drivers of inflation between 2020 and 2022 as the COVID-19 pandemic and the subsequent policy responses. The pandemic triggered significant supply chain disruptions and economic shutdowns, creating an adverse supply shock. Simultaneously, he noted, both fiscal and monetary policies were aggressively focused on stimulating growth, further exacerbating inflationary pressures.
The fiscal stimulus following the health crisis was "supersized" compared to the response after the financial crisis, which Tracy said contributed to the surge in inflation. The Federal Reserve initially expected that the supply shock would resolve quickly after vaccine development and rollout, leading to a perception that inflation was merely "transitory." In addition, the Fed did not recalibrate its monetary policy to take account of the aggressive fiscal policy.
However, as Tracy has written here, here, and here, the Fed had previously struggled to meet its 2% inflation target, averaging only 1.7% in the years leading up to COVID-19. The Fed moved to adopt the flexible average inflation target (FAIT) approach, where it would not necessarily react to inflation above 2% if this was preceded by a period of low inflation. The initial rise in inflation was an opportunity for the Fed to show the markets that it was serious about FAIT. This change in mindset may have led the Fed to take a more relaxed response to early inflation increases in 2021. It acted slowly in pushing down inflation, not moving until 2022 to increase interest rates to counter inflation.
Tracy emphasized the delicate trade-off central banks face when dealing with adverse supply shocks. Monetary policy is typically designed to address demand shocks, stimulating the economy during slowdowns. However, when supply is constrained, stimulating demand can worsen inflation. The same tradeoff exists for fiscal policy.
Tracy addressed the policy contrasts of the 2008 financial crisis to the COVID-19 responses. He also highlighted the impact of the Fed's balance sheet policies, particularly the purchase of longer duration bonds, which drove down term premiums and mortgage rates leading up to the pandemic. This led to historically low mortgage rates, creating a "lock-in effect" where homeowners were subsequently reluctant to move due to the higher cost of new mortgages. As interest rates rose and housing inventory remained constricted, housing and rent prices increased, adding financial pressure on households.
Looking ahead, Tracy suggested that some of the factors contributing to inflation between 2020 and 2022 were still lingering, particularly the long tail from the fiscal stimulus.
Tracy expressed cautious optimism about decreasing inflation in 2025. He believes the Fed is aware of the perception that it was slow to respond and is aiming for a "soft landing" by bringing inflation down without triggering a recession. This goal is likely why the Fed is taking a more patient approach, avoiding being overly aggressive with policy rates and thereby allowing inflation to come down slower without risking a recession.
Addressing the critical need for fiscal responsibility, Tracy pointed out that the U.S. government's debt has increased significantly, and interest expenses are rising. The aggressive fiscal response during the crisis and the lack of focus on controlling debt are concerning trends. He called for a willingness to discuss entitlement programs and to find ways to grow the economy, such as streamlining regulations and encouraging private sector investment.
When asked what concerns him, Tracy noted that we need sensible immigration policies to help support labor supply growth and boost economic growth. Furthermore, he cautioned that the U.S. economy's ability to continue to grow above trend is limited by the slowdown in the rest of the world. He noted that Europe, particularly Germany and the UK, is facing economic challenges, and China's growth is also slowing. Geopolitical risks, such as the Ukraine-Russia war and the Palestinian-Israeli conflict, add further uncertainty to the global economic outlook.
