The writer is a philanthropist, investor and economist

The stock market was rattled from its record highs of the past few weeks as investors who rely on low interest rates to ‘justify’ high valuations faced the prospect of tighter monetary policy .

This could be a prelude to more trouble. The US Federal Reserve appears to be walking a tightrope, with the potential for policy error on either side.

On the one hand, consumer price inflation in the United States reached an annual rate of 7.1% in December, and the central bank seems behind the curve to contain it as it continues to widen its balance sheet, keeping its benchmark federal funds rate close to zero. On the other hand, the spike in inflation emerged alongside supply disruptions, a gradual reduction in pandemic-related budget deficits and signs of weakening business activity. That leaves the Fed at risk of tightening policy in a slowing economy.

Yet these risks may be minor compared to the policy mistake the Fed has already made, abandoning a systematic policy framework for more than a decade, in favor of a purely discretionary one.

“Systematic” in this context means a framework in which policy tools such as the level of the federal funds rate maintain a reasonably stable and predictable relationship with observable economic data such as inflation, employment and output gap” between the real GDP produced and its estimated full employment potential.

Systematic policy allows individuals and financial markets to anticipate the general direction of monetary policy based on observable data. In contrast, a purely discretionary policy is like inconsistent parenting; having set no limits, any failure to appease is met with groans of surprise, crisis and anger.

In 1993, Stanford economist John Taylor proposed a systematic framework for evaluating what the federal funds rate should be given the level of inflation and the output gap. Taylor’s rule and related guidelines reflect the real federal funds rate reasonably well from 1950 to 2003.

The similarity weakens after 2003, and particularly after 2009 due to changes in Fed monetary policy. Yet, the gap between the actual fed funds rate and the systematic guidelines has little beneficial impact on subsequent economic outcomes. This does not mean that monetary policy is irrelevant. On the contrary, the advantage of monetary policy reflects the extent to which it reacts systematically to non-monetary variables.

Describing a small change in the fed funds rate as a serious policy error grossly overstates the correlation between monetary policy and economic performance. Information on the monetary policy stance offers surprisingly little improvement or significant impact on forecasts for GDP growth, employment growth and inflation. Similarly, the relationship between unemployment and general price inflation is more like a scatter than a well-defined “curve” or a manageable policy framework.

Ultimately, the Fed’s central policy error may have nothing to do with the speed at which it tapers its asset purchases or the timing of the next rate hikes. Instead, the critical policy error may turn out to be the consequences of discretionary policy in financial markets. The Fed has encouraged a decade of speculation in search of yield as investors try to avoid being among the holders of $6 billion in zero-rate hot potatoes.

By relentlessly depriving investors of a risk-free return, the Fed has spawned a speculative bubble in all assets that may now leave investors with low risk but no return. Valuations are still near record highs.

It is true that low interest rates favor high stock market valuations. But it is less appreciated that once valuations are high, low interest rates do nothing to mitigate the low long-term market returns that typically ensue.

In 1873, the economist and journalist Walter Bagehot wrote of savers’ aversion to low rates: “John Bull can bear many things, but he cannot bear interest rates of 2%”. Forgetting that, in 2003 the Fed sent investors on a quest for yield to find alternatives to short-term 1% interest rates. Investors found that alternative in mortgage-backed securities, with ultimately devastating consequences.

The Fed has now encouraged an even broader and more prolonged speculative episode. It can only be prolonged by aggravating its consequences. The way forward is to embark on a well-heralded return to systematic policy, never forgetting to ask whether the weak effects of monetary discretion on real economic outcomes are worth the risk of misinvestment and speculative distortion.