For the past five years, the Federal Reserve has failed on both fronts of its dual mandate. Inflation has persistently deviated from the 2% target, and the primary engine of job growth has been systematically suppressed under policy pressure. The root of this failure lies not in forecasting errors, but in the inherent contradictions of the policy framework itself.
By the end of 2025, the year-over-year headline PCE inflation rate had risen to 2.9%, with core PCE at 3.0%. In December alone, both measures climbed by 0.4 percentage points month-over-month. Meanwhile, cumulative inflation in the US from 2021 to 2025 reached 25%, the highest in a decade. Against this backdrop, the Fed announced in October 2025 that it would pause its balance sheet runoff starting December 1, even though its balance sheet remains far above historical norms.
This decision has sparked market skepticism: Is the Fed truly controlling inflation, or is it merely prolonging the sovereign debt bubble?
The impact of this policy mix on the market is already clear. The average interest rate on short-term loans for small businesses rose to 8.4% in December 2025, with only 25% of owners reporting regular borrowing activity—a historic low. Squeezed by tight credit and rising labor costs, small and medium-sized enterprises (SMEs), which account for over 51% of net job growth, are ultimately bearing the brunt of the tightening policy's cost.
Misdiagnosis of Inflation's Root Cause Leads to Misguided Policy Tools
A fundamental flaw exists in the Fed's policy framework: it attributes the causes of inflation to an overheated private sector rather than fiscal expansion.
Kritzman of the MIT Sloan School of Management concluded that "from a mathematical perspective, the overwhelming driver of the 2022 inflation surge was federal spending, not supply chains." However, the Fed's policy response has been the opposite—penalizing private sector borrowers with higher interest rates while providing implicit financing support for government debt through quantitative easing and a bloated balance sheet, effectively lowering the cost of financing the fiscal deficit.
Between 2021 and 2024, the sharp expansion of the money supply, the persistent swelling of the fiscal deficit, and ultra-low policy rates combined to create a massive amount of ineffective demand, far exceeding the economy's productive capacity. Even after supply chains normalized and energy prices fell back to pre-2022 levels, overall inflation did not subside. This fact alone proves that supply shocks were not the primary cause of inflation; excessive monetary and fiscal policy were the core issues.
More critically, after the end of the COVID-19 national emergency, U.S. government spending remained roughly $2 trillion above emergency pandemic levels. Not only did the Fed fail to act as a counterbalance, but it also reinforced the market illusion that "deficits can be painlessly financed" through quantitative easing, objectively encouraging continued fiscal expansion.
Small and Medium-Sized Enterprises Bear the Strain, Facing Structural Damage to the Job Market
The asymmetry of the Fed's policy framework has produced significant structural distortions in the employment market.
Data shows that businesses with fewer than 250 employees account for over 51% of net job creation in the US. From the first quarter of 2023 to the end of 2025, these firms generated 58% of net private sector job growth. Unlike large publicly listed companies, which can smooth capital costs through bond issuance, syndicated loans, and equity financing, SMEs are highly dependent on bank credit, primarily financing through floating-rate loans, personal guarantees, and commercial real estate collateral.
When benchmark interest rates rise sharply, the impact of credit constraints on SMEs is far more severe than on large corporations. Large companies can delay expansion, but small businesses facing refinancing pressures often have to cut inventory, halt hiring, abandon equipment investment, or even shut down. Research shows that credit constraints on SMEs can explain about one-third of the total employment response to monetary policy shocks.
At the same time, for many banks, holding government bonds is both safer and more profitable than lending to households and businesses, further squeezing the supply of credit to the real economy. The Fed claims to support full employment, yet its institutional design systematically punishes the core source of job growth—a fundamental internal contradiction.
Balance Sheet Tool Left Idle, Policy Signals Misread
Beyond interest rates, the Fed also possesses the equally important policy tool of the balance sheet, but its use over the past several years has drawn repeated criticism.
Since initiating balance sheet runoff in June 2022, the Fed has reduced its securities holdings by roughly $2.2 trillion. However, the decision to pause the runoff in October 2025 sent a clear signal to the market: the central bank is more inclined to maintain the stability of the sovereign bond market than to pursue genuine monetary normalization. Critics argue that the Fed's balance sheet has never truly returned to normal—each decline is followed by a new round of expansion, creating a cycle.
In contrast, if the Fed were to accelerate the balance sheet contraction in a transparent and predictable manner, allowing Treasury bonds and mortgage-backed securities to mature naturally more quickly, it could effectively withdraw excess market liquidity without shifting the entire adjustment burden onto entrepreneurs and working families. This would also force government bonds to be financed at prices closer to their true market value, thereby imposing substantial discipline on fiscal policy.
Regarding potential policy direction changes, the stance of Kevin Warsh is noteworthy. He clearly distinguishes the differential impact of interest rate and balance sheet tools, arguing that balance sheet policy more directly benefits financial asset holders, while interest rate policy permeates every corner of the real economy. He advocates for modestly lowering interest rates while advancing the balance sheet runoff, rather than treating rate hikes as the only option for every inflation concern. This approach may offer a viable path for the Fed to navigate its current policy dilemma.
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