The author is a philanthropist, investor and economist

Stocks have wobbled from record highs in recent weeks as investors reliant on low interest rates to “justify” high valuations face the prospect of tighter monetary policy.

This could be a prelude to more turmoil. The Fed appears to be walking a tightrope, with the potential for policy mistakes on both sides.

On the one hand, U.S. consumer price inflation hit an annualized rate of 7.1% in December, and the central bank appears to be behind the curve to curb inflation as it continues to expand its balance sheet, keeping its benchmark federal funds rate near zero. On the other hand, soaring inflation has coincided with supply disruptions, a tapering of the pandemic-related fiscal deficit and signs of weakening business activity. That puts the Fed at risk of a slowdown from policy tightening.

However, these risks may be insignificant compared to the policy mistakes the Fed has already committed, which for more than a decade has abandoned a systemic policy framework in favor of a purely discretionary framework.

In this context, “systemic” means that policy tools (such as the level of the federal funds rate) remain reasonable with observable economic data (such as the “output gap” between inflation, employment, and real GDP) A framework for stable and predictable relationships. Products and their estimated full employment potential.

Systematic policy allows individuals and financial markets to predict the overall stance of monetary policy based on observable data. In contrast, purely discretionary policies are like inconsistent parenting. With no boundaries set, any unrelenting behavior invites surprise, crisis, and howls of tantrums.

In 1993, Stanford economist John Taylor proposed a systematic framework for assessing what the federal funds rate should be based on inflation levels and the output gap. From 1950 to 2003, the Taylor Rule and related guidelines reflected the actual federal funds rate fairly well.

This similarity weakened after 2003, and especially after 2009, due to a shift in Fed monetary policy. However, deviations of the actual federal funds rate from systemic guidelines had little favorable effect on subsequent economic outcomes. This does not mean that monetary policy is irrelevant. Rather, the benefits of monetary policy reflect the degree to which it responds systematically to non-monetary variables.

Characterizing small changes in the federal funds rate as a serious policy error greatly overestimates the correlation between monetary policy and economic outcomes. Surprisingly, information on the stance of monetary policy has had little improvement or meaningful impact on forecasts of GDP growth, employment growth, and inflation. Likewise, the relationship between unemployment and headline price inflation is more of a bird’s-eye scatter than a well-defined “curve” or a manageable policy framework.

At the end of the day, the Fed’s central policy mistakes may have nothing to do with how quickly it scales back its asset purchases or the timing of its next rate hike. Instead, critical policy mistakes may prove to be the result of discretionary policies in financial markets. The Fed has encouraged a decade of yield-seeking speculation as investors try to avoid becoming holders of the $6 trillion hot potato of zero interest rates.

By ruthlessly depriving investors of risk-free returns, the Fed has spawned an all-asset speculative bubble that may now leave investors with little risk but little reward. Valuations remain near record extremes.

Indeed, low interest rates encourage stock market valuations to rise. But what is less understood is that once valuations rise, low interest rates do little to alleviate the poor long-term market returns that usually follow.

In 1873, economist and journalist Walter Bagehot wrote of savers’ aversion to low interest rates: “John Bull could endure many things, but he could not bear 2 percent.” Forgetting that, the Fed in 2003 had investors looking for yield as an alternative to the 1% short-term rate. Investors discovered an alternative in mortgage securities, with devastating consequences.

The Fed is now encouraging broader, broader speculation. It can only be prolonged by making the consequences worse. The way forward is to start publicly announcing a return to systemic policy, never forgetting to ask whether the small impact of monetary discretion on real economic outcomes is worth the risk of misinvestment and speculative distortions.