The Reaction Function

26 August 2025

The Federal Reserve reaction function is often presented as clean and rules based. If the labour market weakens or inflation expectations fall below target, they cut. If both are strong, they hold or hike the funds rate. However, history suggests that the reaction function is more complex. The Fed is not just calibrating inflation and employment (chart 1); it is managing system fragility. The longer the Fed insists on maintaining policy data dependent, pointing to solid employment or firm inflation surveys, the more it ignores the slow accumulation of stress in credit, funding markets and trade channels. Put another way, labour and inflation are lagging indicators. In contrast, fragility is what forces abrupt policy pivots.

Chart 1

Source: Bloomberg

As we have often noted, long phases of stability where policy rates are anchored below neutral or equilibrium led to abrupt episodes of instability because that contributed to a build up in system wide leverage. Stated differently, there is an intimate link between liquidity, leverage, and volatility. That was evident in 1998 with LTCM, in 2008 with mortgage-backed collateral and in 2020 with repo and global dollar funding. None of these crises were foreshadowed by employment or PCE inflation, they were cracks in the system from a build up in leverage that turned into breaks. When the breaks came, the Fed did not execute a careful adjustment in response to labour or inflation data, it responded to stabilise markets. For market participants, the other major risk in all the episodes above was “correlation". If you want to know where future episodes of instability might arise, follow the leverage. 

Chair Powell’s speech at Jackson Hole was perceived as dovish on his assessment of the inflation and employment balance of risks. That reinforced odds the FOMC will likely deliver a 25-basis point rate cut at the September meeting. However, more importantly, Powell explicitly abandoned the idea of “achieving” a 2% inflation rate in this cycle and “reaffirmed” 2% as only a long-term aspirational goal as measured by long-term inflation expectations anchored (whatever that means) at 2%. This is profoundly dovish and an abandonment of the 2% inflation target.

The way gold and precious metals responded to this news was telling. Gold tends to perform well when the “Federal Reserve is inflationary.” Moreover, we also fear that Fed independence is at risk. From a pure price perspective, gold has been in a consolidation phase for a few months before a potential continuation of the bull market. Note we added back to gold producers at the start of August. That position has gained 16% from the early August low.

To reinforce a point we made last week, rate cuts are almost never the bold, pre-emptive acts that policymakers like to frame them as. They are reactive by design or a signal that something beneath the surface has cracked. The Fed doesn’t ease when macro conditions are healthy; it cuts when stress is visible to insiders. The headline in the Wall Street Journal following the September 2007 FOMC meeting was “stocks surge after Fed rate cut. (chart 2 – note that final thrust on the chart)”. Clearly that was not an all-clear moment for equities but the start of a major drawdown episode and earnings recession in risk assets. There are exceptions such as the “mid-cycle” slowdown in 1995. However, soft landings are the exception, not the rule. The context is that the S&P500 (global risk proxy) trades in the 95^th percentile of its valuation history. Put another way, the risk-reward is not attractive on an extended time frame.

Chart 2

Source: Bloomberg

20250825_The_Reaction_Function.pdf

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