Clive Crook: The Fed is still struggling to get its story straight
Sat., June 18, 2022
Much as I sympathize with the Federal Reserve as it grapples with an economy in extremely trying circumstances, I believe it could be doing better in one crucial respect: helping financial markets to align their expectations with its thinking.
Analysts could be forgiven for saying that the Fed just aligned itself with them, rather than the other way around. It raised its policy rate by 75 basis points this week, not by the 50 points previously advertised. After the unexpectedly high inflation figure for the year to May was published last week, analysts abruptly called for a bigger rate increase. The Fed, reversing its earlier guidance, duly delivered. You might wonder, who’s in charge?
To be clear, if financial markets were merely anticipating the policy rate demanded by changing financial conditions, given the Fed’s understanding of its job, that would be fine. Actually, if markets were pre-aligning themselves with policy makers’ declared ends and means, that would be ideal: The Fed does its job, and the markets help by correctly predicting its judgements. At the moment, though, any such interpretation is quite a stretch – because the supporting analysis, from Fed and commentators alike, betrays confusion over those very ends and means.
Consider the obsessive focus, ahead of the announcement, on whether the policy rate should rise by 50 or 75 basis points. In itself, that margin is of vanishingly small economic significance. It matters only because of all the other things it might or might not say about the Fed’s calculations. Has the central bank changed its understanding of the processes driving inflation – on the basis, by the way, of very little new information? Has it changed how it balances its dual mandate – that is, does it now care more about lowering inflation than about maintaining high employment? (If so, why?) Has it changed the timeframe over which it proposes to get inflation back under control, or about the projected policy rates needed to get inflation down as originally intended, or both?
The answer to all these questions is, who knows? And it’s little short of absurd that the choice between 50 and 75 basis points raises them in the first place. All by itself, that ought to tell the Fed that its messaging is failing – and making a difficult job even harder.
Current monetary policy has to contend with two fundamental problems. The first is a series of unprecedentedly large and complex supply shocks. The other is a legacy policy framework that was (arguably) well-suited to persistently less-than-target inflation but is badly suited to these new conditions.
If inflation is caused by surging demand, reducing demand is the right remedy; to the extent it’s caused by sudden and temporary restrictions of supply, reducing demand is a mistake. Compounding this difficulty, the Fed is still yoked to a model of “forward guidance” that calls attention to the future path of interest rates more than to the future path of demand. This made sense when the policy rate was zero and needed to fall further, because the Fed thought promising “low for longer” was the best it could do. This “zero lower bound” no longer applies. Yet the Fed is still in forward-guidance mode, tightening policy with an extra quarter of a point and telling markets to look at the projected path of rates over the coming year – all the while emphasizing the need to watch the data and reserving the right to pivot without notice if necessary.
Well, which is it? Monetary policy is complicated, but it doesn’t need to be quite so self-contradictory. The remedy for both problems – the outsize role of supply shocks and the confusion over forward guidance – is to explain policy in terms of current and projected aggregate demand. In effect, this allows the Fed to be agnostic about short-term changes in productive capacity, and lets inflation rise temporarily above target when supply conditions worsen. In addition, it directs attention away from the expected path of interest rates. Meeting by meeting, the question for the Fed’s policymakers will be this: What should the interest rate be now, not six months or a year from now, to push forecast demand on to the right track?
That’s a difficult question, to be sure. And the answer to it will change as data comes in. It bears repeating: Nothing can make monetary policy easy. But there’d be less confusion, less attention to things that don’t matter, and less delay in adjusting policy, if the Fed stopped organizing its announcements around a projected path for its policy rate.
Things can change suddenly. The Fed can’t say what the appropriate interest rate will be over the course of the next two years. And if the outlook for demand should shift abruptly, in either direction, the interest rate should shift abruptly, too. On Wednesday, Chairman Jerome Powell rightly stressed the need to stay nimble. Forward guidance on interest rates is the opposite of nimble. The Fed’s approach to messaging needs to change.
Clive Crook is a Bloomberg Opinion columnist and member of the editorial board covering economics. Previously, he was deputy editor of the Economist and chief Washington commentator for the Financial Times.
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