With inflation at its lowest level since 2021 and unemployment on the rise, market participants and observers are looking nervously at the Federal Reserve. Is it behind the curve again, as it was when it started raising interest rates two years ago? Is it lowering interest rates too late to avoid a recession now, just like it failed to tighten policy until the economy had started overheating then?
The Fed should be setting monetary policy in a forward-looking manner, based on its best understanding of current conditions and forecasts of future conditions. It has deviated significantly from this practice in recent years, perhaps most explicitly when it started relying heavily on what economists call “forward guidance” during the period after the 2007-2008 global financial crisis.
Forward guidance may sound forward-looking, but it’s actually the opposite. When I tell you today what I will do tomorrow, tomorrow I will have based my action on what I knew yesterday, instead of actually reacting to the moment.
The Federal Reserve provided forward guidance in two different ways. First, in 2012 it started publishing the so-called dot plot as the centerpiece of its economic projections. This figure shows Federal Open Market Committee (FOMC) participants’ forecasts of the optimal short-term interest rate. This kind of forward guidance is sometimes referred to as Delphic, after the oracular priestess at the temple of Apollo, and is in principle merely predictive in nature. But at any point in time, FOMC participants—the members of the Board of Governors in D.C., the president of the New York Fed, and a rotating set of four regional Fed presidents—will of course know what their past predictions of their current and future decisions were.
It also started committing to a path of short-term interest rates in an attempt to strengthen the effectiveness of its policies. This second kind of forward guidance, sometimes referred to as Odyssean, like the eponymous hero of Homer’s epic, is meant to signal to market participants that monetary policymakers will resist the siren song of higher- or lower-than-announced interest rates. In theory, this type of forward guidance goes well beyond mere forecasting: The explicit promise is that policy will not deviate from the announced path even if it turns out not to be the optimal policy path.
The idea was to influence the expectations of consumers, firms, and market participants both directly, through the projections, and indirectly, by committing at least in principle to an announced path of interest rates. Not that these two types of forward guidance were always easily distinguishable.
The second type of forward guidance is time-inconsistent by its nature. Time inconsistency simply means that what might seem optimal today, such as a specific future rate path, will not necessarily be the best policy in the future, when economic conditions may look very different from today. If the announced path of interest rates was the one the Fed would necessarily find optimal, announcing it as the path the Fed would follow would not make a difference. But if it was not, then the Fed would be tempted to deviate from the announced path, and it would in fact be costly to remain on it. Remaining on its announced course for too long is, in fact, what the Fed did in 2021 and, we would argue, is what the Fed is doing today.
In August 2020, the FOMC adopted a new monetary policy framework, flexible average inflation targeting. Under this framework, the Fed targets a 2 percent average inflation across time, and no longer at every point in time, as had been the case before. Following a period of inflation below 2 percent, for example, the Fed should in theory seek to achieve a compensating period of above 2 percent inflation.
One way to understand this new framework is that with it the Fed tries to resolve the time-inconsistency problem by accepting the cost of remaining on the path announced in its forward guidance even when it has become clear that path is no longer optimal. This makes sense if this cost is smaller than the benefits that accrue from forward guidance: The additional consumption and investment triggered by the expectation that interest rates will remain low for longer. But those benefits were likely always small—the Fed has a range of policy instruments in addition to the federal funds rate, and Congress and the executive branch have access to even more macroeconomic policy tools. And they are close to nonexistent when interest rates are well above zero, as they are now, and the Fed is no longer limited in the use of its main policy instrument: the federal funds rate.
On some level, the Federal Reserve has come to realize this. While its new framework was designed in response to the low inflation of the 2010s, if we take it seriously as a framework instead of a mere policy response, we should now be entering an extended period of below-target inflation. That below-target inflation would offset the recent elevated rates of inflation to deliver on-target average inflation. While it is possible that will happen, it is not the Federal Reserve’s intention. This repudiation of the monetary policy framework the Fed adopted just four years ago is a good first step—but a number of additional steps should follow, and both forms of forward guidance should also be abandoned.
Now that the U.S. is no longer at the zero lower bound—now that the federal funds rate is no longer at or close to zero—the central bank can simply change interest rates to influence financial and broader economic conditions. It no longer has to be afraid of changing course when conditions demand that it do so. To the extent that it fears contradicting its own forecasts, which were never particularly good in the first place, the dot plot is now counterproductive.
There is no reason to convince markets that one rate cut implies a predefined or monotonic sequence of rate cuts, either. Moving away from the idea of necessarily and inevitably smooth cycles in the federal funds rate may also remove some of the pressure, political and otherwise, from what is now the momentous decision to deliver an initial rate hike or cut.
And there is no longer a need for the FOMC to convey an image of consensus with unanimous votes. Not a single member of the Federal Reserve Board of Governors has cast a dissenting vote at an FOMC meeting since the financial crisis, even though such votes were common in previous decades. Unanimity may lend credibility to an announced course of action, but in the absence of a need for such credibility it raises concerns of groupthink and capture by permanent staff.
But old habits die hard. The Fed now it has to provide guidance so that households and firms can plan for the future. It claims that it cannot make the “mistake” of lowering rates and then raising them again because it would produce too much uncertainty.
What actually generates uncertainty is the difficulty intrinsic in figuring out what the terminal or neutral interest rate of each loosening and tightening cycle will turn out to be. Macroeconomic forecasting is simply quite hard, and figuring out when the economy is entering into a recession notoriously so. Many observers are focused on indicators like the so-called Sahm rule, which compares the recent increase in the unemployment rate to the increases associated with past downturns and suggests that we are currently in a recession. It was based on just seven historical episodes from the past 50-odd years and seems to have misfired twice since its 2019 introduction by economist Claudia Sahm. It did not notice the pandemic-driven recession until after the U.S. Congress had already passed massive fiscal support through the CARES Act. And this year even Sahm, its creator, believes it has generated a false positive.
Minor rate fluctuations, on the other hand, are easy to manage—and rates markets are quite volatile as they are. It is rapid escalations of interest rates—like the ones seen in 2022-23—that households cannot realistically hedge against. The fact that they went up all at once, nice and smooth without course reversals along the way, was of little help to young families hoping to buy a home.
Current Fed attitudes—the preference for waiting until the last moment to start a new loosening or hiking cycle, the fear of going back and forth—exacerbate such short-run interest rate dynamics. The Fed needs to let go of those attitudes and focus on what can be, unburdened by what has been.
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