“The Fed Doesn’t Control the Shocks. It Controls Its Grasp of Them”

Overcorrection is a well-documented behavioral risk: respond to one mistake with excessive force in the other direction and you create a second, often larger error.

In 2021, Federal Reserve officials misread the inflation signal. Their models said supply disruptions would resolve and prices would fall on their own. They were wrong, and the costs were real. The lesson the institution drew: do not misread inflation again. And that lesson, when it hardens into reflex, is how the next mistake gets made.

This week's FOMC meeting is where that reflex becomes dangerous. The economy is softening. Inflation remains above target. A Middle East war is pushing oil prices even higher. Each of those facts, filtered through the 2021 lesson, looks like confirmation: move faster this time.

The committee will hold rates this week. The risk is what comes after: what the committee's signals say about its diagnosis. If those instincts drive policy, the cure could become the disease.

What the Data Show

The data facing Fed policymakers are mixed, but they have clearly caught the committee's attention.

Q4 GDP came in at 0.7%, revised down from an already weak first estimate, a number that predates the Iran war and the disruptions it brought. Core PCE is 3.1%, above target and not moving down fast enough. Payrolls have declined three times in five months, and the December revision flipped from a gain of 48,000 to a loss of 17,000.

There are genuine green shoots. Consumer spending held up in January. Health care shed nearly 30 thousand jobs mainly because of a strike now settled; those workers return in March. And shelter inflation, which carries significant weight in core PCE, still reflects where the rental market was six months ago, not where it is today.

Then the Middle East war arrived.

Strikes have hit energy production across the region, and precautionary shutdowns have compounded the disruption. Traffic through the Strait of Hormuz has been severely impeded. The result: a genuine energy supply shock and sharply higher oil prices landing in a U.S. economy already softening.

The hold at this meeting is not in question; markets put the probability near 100%. It is the Central Bank's views of what they see or anticipate on the horizon.

How a Wrong Diagnosis Hurts

A wage-price spiral is a specific mechanism: prices rise, workers demand higher wages to keep up, those wages push prices higher still, and the loop feeds on itself. The inflation of the 1970s ran on that machinee -- wage contracts that automatically escalated pay as prices rose.

Supply shocks are different. They raise prices but do not automatically create a self-reinforcing wage-price process.

If the Fed reads today's data through the wrong lens -- seeing a spiral where there is a shock -- the response will show up in its signals: a hawkish dot plot, language taking cuts off the table, and markets pricing a tighter path before any rate move occurs.

That is the risk this week.

A war-driven price spike and stubborn inflation require patience, not the playbook built for a wage-price spiral.

The 1970s Machine Is Not Running

The inflation of the 1970s was driven by wage contracts that automatically escalated pay as prices rose. More than half of major private-sector union contracts had cost-of-living adjustments built in. Today fewer than one in five do, and only about 6% of private-sector workers belong to unions at all.

Compensation costs rose roughly 3.4% over the past year, slower than a year ago, not faster. With core PCE at 3.1%, real wage gains are essentially zero.

The loop is not running -- yet.

Inflation expectations are the early warning system. The University of Michigan's five-year measure sits near 3.2%, uncomfortably close to core inflation. Market-based long-run measures remain closer to 2.2%. Workers, who ultimately set wages, are less sure.

If the energy shock pushes core toward 3.5% and household expectations follow, the risk of a true wage-price process would rise and the policy advice would change.

But we are not there.

Reading every weak jobs print as proof the spiral has already begun is the overcorrection in real time. The Fed would be tightening against a machine that is not running.

The Dots , Powell , and Fedspeak Will Reveal the Call

The dot plot will be the clearest signal. If the median shifts toward fewer cuts and a longer hold, the committee is reading today's mix as an entrenched inflation problem. If the dots keep room for cuts tied to progress on both inflation and growth, that is closer to the right story: powerful shocks, a fragile economy, and a mandate that runs in both directions.

Powell's press conference will reveal the framing. The question is whether he treats the energy disruption as something to monitor carefully or as a reason to harden the stance across the board.

Speeches and statements from Fed officials in the days after the meeting are the final read. The dots show where FOMC participants stood at the meeting. The speeches reveal what they are thinking after it.

If They Misread It, Markets and Workers Pay

Markets have already begun pricing the risk that the Fed will stay tighter for longer. Equity markets are down roughly 3% since the war began, posting three straight weeks of losses. A dot plot pushing cuts further out would compound that damage. So would language signaling that cuts are off the table.

Bond yields would rise and credit spreads would widen, tightening financial conditions into an economy already slowing. That tightening would show up quickly in weaker hiring, delayed investment, and more of the softness the Fed says it wants to avoid.

These are not abstract financial variables. When credit tightens in an economy already slowing, the workers most exposed are the ones with the least cushion -- the ones already paying more at the pump and most vulnerable to a lost job.

Hold Now, Keep Conditional Cuts on the Table

At the March meeting, the case for holding at 3.5 to 3.75% is not close. Cutting into a live energy disruption, with core PCE still at 3.1% and household inflation expectations above 3%, is not the right move. It would reopen the question of whether the Fed really means 2%, just as that question was starting to close.

Inside the committee, the split mirrors the public debate. Hawks will point to sticky core readings and Michigan's expectations and argue that any hint of dovishness is dangerous after "transitory." They are right to worry about credibility. They are wrong if they treat "hold forever" as the safe path regardless of how growth and inflation evolve.

Paralysis in an economy near stall speed is its own credibility test, one that falls hardest on workers with the least savings.

Mr. Warsh will inherit this debate on day one. Getting the diagnosis right before that transition is not a courtesy. It is the work.

Hold the rate. Name the risks on both sides. Be clear about what would justify easing: not simply a couple of weak jobs reports, but weaker growth alongside evidence that the expectations cushion is holding.

The dot plot should reflect that.

What Is at Stake

The families paying more at the pump and watching paychecks shrink do not need the Fed to prove it learned from "transitory." They need it to have actually learned from it.

When the diagnosis is wrong, the people who pay are never the people in the room.

The lesson from that mistake is not "move faster." It is "read the situation correctly." A central bank that overcorrects into a supply shock has not learned from 2021. It has simply replaced one mistake with another.

The Fed does not control the shocks hitting the economy. It does control whether it understands them.