Bill Dudley: One way the Fed can bolster its defenses

Federal Reserve Chair Jerome Powell is doing an excellent job of responsibly managing U.S. interest rates despite escalating attacks from President Donald Trump. When it comes to the Fed’s broader approach to monetary policy, though, he still has some work to do.

Powell sent a clear signal at last week’s Jackson Hole Economic Policy Symposium: A 25-basis-point reduction in short-term interest rates will be on the table at the Fed’s September policy-making meeting. He noted that easing “may” be appropriate, given that monetary policy is still in “restrictive territory” at a time when the risk of a weaker labor market can materialize “quickly” and inflationary expectations are well-anchored enough to handle temporary tariff-induced price increases. Markets reacted by dialing up the probability of a September rate cut to nearly 90% – though much still depends on the next set of employment reports.

Of greater long-term importance will be the Fed’s revisions to its broader monetary-policy framework, also released during the symposium. They largely reverse the last set of changes to the framework, which played a role in the central bank’s failure to contain inflation during the COVID-19 pandemic in 2021 and 2022. Adopted after a long period of too-low inflation, it encouraged overshooting the Fed’s 2% target to offset past inflation downside misses and prioritized maximum employment, prompting policy makers to keep interest rates at zero even as unemployment fell to unsustainable levels and consumer prices rose more than 5% from a year earlier.

The Fed has now returned to a symmetric average inflation targeting regime: Misses to the upside are treated no differently than those to the downside. It will seek to maintain the maximum level of employment consistent with price stability, rather than eliminating “shortfalls” or ensuring employment is “broad-based and inclusive.” Preventing short-term interest rates from getting stuck at the zero lower bound “remains a potential concern” but is no longer “our primary focus,” as Powell put it. This is because the “neutral” interest rate – the rate that neither hinders nor stimulates growth – has risen, giving the Fed more room to cut.

The changes are welcome as far as they go. They restore the Fed’s ability to act pre-emptively when inflation threatens to climb above its 2% target, and they rightly put the employment and price-stability objectives on a more equal footing. Yet they fail to fully address some key shortcomings in the way the central bank implements monetary policy.

In particular, the Fed needs to develop a cost-benefit framework to guide its use of quantitative easing. The cost of the Fed’s 2020-22 program will exceed $500 billion in terms of foregone interest paid to the U.S. Treasury. It should also better distinguish large-scale asset purchases aimed at restoring market function from those that seek to provide additional monetary policy stimulus at the zero lower bound.

Beyond that, the Fed needs to improve how it communicates the economic outlook and its likely reaction. The Summary of Economic Projections, released at every other policy-making meeting, overemphasizes officials’ modal forecasts. Looking at their interest-rate projections, one can’t determine whether differences are due to divergent forecasts versus disagreement about how the Fed should react to a particular set of economic circumstances. Rather than tinkering around the edges, the Fed should move to a detailed staff forecast with alternative scenarios – a strategy used by the European Central Bank, which also has a big and geographically diverse membership.

Given the extreme political pressure from the Trump administration, the Fed might be inclined to hunker down and do less – to avoid the implicit admission of flaws in the prior framework. That would be a mistake. To maintain its independence, it should seek to have the most effective and comprehensive monetary policy framework possible. As the world and the structure of the financial system evolve, the Fed needs to keep pace.

Bill Dudley is a Bloomberg Opinion columnist. A former president of the Federal Reserve Bank of New York, he is a nonexecutive director at Swiss Bank UBS and a member of Coinbase Global’s advisory council.