--- title: "The Fed's Policy Paradox: Tightening Credit for the Private Sector While Tolerating Government Deficit Expansion" type: "News" locale: "en" url: "https://longbridge.com/en/news/295404869.md" description: "Over the past five years, the Federal Reserve's policy framework has exhibited inherent contradictions: it misjudged inflation driven by fiscal expansion as an overheated private sector, leading to interest rate hikes that severely impacted small and medium-sized enterprises (SMEs) heavily reliant on bank credit (accounting for over 51% of net job growth); meanwhile, it facilitated sovereign debt financing through a large-scale balance sheet, failing to impose substantial fiscal constraints. The market is calling for a restructuring of policy logic, potentially shifting towards accelerating balance sheet reduction to withdraw liquidity while lowering interest rates to alleviate pressure on the real economy" datetime: "2026-08-10T12:08:06.000Z" locales: - [zh-CN](https://longbridge.com/zh-CN/news/295404869.md) - [en](https://longbridge.com/en/news/295404869.md) - [zh-HK](https://longbridge.com/zh-HK/news/295404869.md) --- # The Fed's Policy Paradox: Tightening Credit for the Private Sector While Tolerating Government Deficit Expansion Over the past five years, the Federal Reserve has failed on both fronts of its dual mandate—inflation has persistently deviated from the 2% target, while the main engine of employment growth has been systematically suppressed under policy pressure. The root of this failure lies not in forecasting errors, but in the inherent contradictions within the policy framework itself. By the end of 2025, the year-over-year overall PCE inflation rate rose to 2.9%, with core PCE inflation reaching 3.0%; in December alone, both increased by 0.4 percentage points month-over-month. Meanwhile, cumulative U.S. inflation from 2021 to 2025 reached a decade-high of 25%. Against this backdrop, the Fed announced in October 2025 that it would pause balance sheet reduction starting December 1, despite its balance sheet remaining far above historical normal levels. This decision has sparked market skepticism: **Is the Fed actually controlling inflation, or merely prolonging the life of the sovereign debt bubble?** The impact of this policy mix on the market is 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 shrinking credit and rising labor costs, SMEs, which account for over 51% of net job growth, are bearing the ultimate cost of tightening policies. ## Misjudged Roots of Inflation, Policy Tools Aimed at the Wrong Target There is a fundamental error in the Fed's policy framework: **attributing the cause of inflation to an overheated private sector rather than fiscal expansion.** Kritzman from 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 went in the opposite direction—punishing private sector borrowers with rate hikes while providing implicit financing support for government debt through quantitative easing and a massive balance sheet, effectively suppressing the financing costs of fiscal deficits. Between 2021 and 2024, a sharp expansion in money supply, continuously expanding fiscal deficits, and ultra-low policy rates combined to create excessive ineffective demand, far exceeding the economy's production supply capacity. Even after supply chains normalized and energy prices fell back to pre-2022 levels, overall inflation did not subside—this fact itself proves that supply shocks were not the primary cause of inflation; excessive monetary and fiscal policies were the crux of the issue. More critically, after the end of the pandemic emergency status, U.S. government spending remained approximately $2 trillion higher than pandemic emergency levels. Not only did the Fed fail to provide a counterbalance, but it also reinforced the market illusion that "deficits can be financed painlessly" through quantitative easing, objectively encouraging continued fiscal expansion. ## SMEs Under Pressure, Job Market Faces Structural Damage The asymmetry of the Fed's policy framework has produced significant structural distortions in the employment sector. Data shows that firms with fewer than 250 employees contributed more than 51% of net job additions in the U.S., creating 58% of net Private Sector Employment growth from Q1 2023 to the end of 2025. Unlike large publicly listed companies that can smooth capital costs by issuing bonds, syndicated loans, and equity financing, SMEs are highly dependent on bank credit, primarily financing through floating-rate loans, personal guarantees, and commercial real estate mortgages. 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, whereas SMEs facing refinancing pressures often have no choice but to cut inventory, halt hiring, abandon equipment investment, or even shut down directly. Research indicates that credit constraints on SMEs can explain about one-third of the total employment response to monetary policy shocks. Meanwhile, for many banks, holding government bonds is safer and more profitable than lending to households and businesses, further compressing credit supply to the real economy. The Fed claims to support full employment, yet its institutional design systematically penalizes the core source of job growth, an internal contradiction that is difficult to justify. ## Balance Sheet Reduction Tool Idle, Policy Signals Misinterpreted Beyond interest rates, the Fed possesses another equally important policy tool—the balance sheet—but its usage has repeatedly drawn criticism in recent years. Since initiating balance sheet reduction in June 2022, the Fed has cumulatively reduced its securities holdings by approximately $2.2 trillion. However, the decision announced in October 2025 to pause balance sheet reduction sent a clear signal to the market: the central bank prefers maintaining stability in the sovereign debt market over pursuing true monetary normalization. **Critics point out that the Fed's balance sheet has never truly returned to normal—each decline has been followed by a new round of expansion, forming a cycle.** In contrast, if the Fed accelerated balance sheet contraction in a transparent and predictable manner, allowing Treasury bonds and mortgage-backed securities to mature naturally at a faster pace, it could effectively withdraw excess market liquidity without shifting all adjustment pressures 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 constraints on fiscal discipline. Regarding potential policy shifts, Warsh's stance is worth noting. He clearly distinguishes between the differential impacts of interest rates and balance sheet tools, arguing that balance sheet policy concentrates benefits more on financial asset holders, while interest rate policy permeates every corner of the real economy. He advocates for moderately lowering interest rates while proceeding with balance sheet reduction, rather than viewing rate hikes as the sole option for addressing every inflation concern. 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