Financial basis

The Fed is still struggling to understand its history

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While I sympathize with the Federal Reserve as it grapples with an economy in extremely difficult circumstances, I think it could do better in one crucial area: helping financial markets align their expectations with its thinking.

Analysts could be forgiven for saying that the Fed simply went with them, rather than the other way around. It raised its key rate by 75 basis points this week, not the 50 points previously announced. After the surprisingly high inflation figure for the year to May was released last week, analysts sharply called for a bigger rate hike. The Fed, reversing its earlier forecast, duly delivered. You might be wondering who is responsible?

To be clear, if financial markets simply anticipated the policy rate demanded by changing financial conditions, given the Fed’s understanding of its job, that would be fine. In fact, if markets aligned themselves with the ends and means declared by policy makers beforehand, that would be ideal: the Fed does its job and the markets help it by correctly predicting its judgments. At the moment, however, such an interpretation is quite a stretch – because the supporting analysis, from the Fed and commentators, betrays confusion about those ends and those means.

Consider the pre-announcement obsession with whether the policy rate should rise 50 or 75 basis points. In itself, this margin is of extremely low economic importance. It only matters because of all the other things he might or might not say about the Fed’s calculations. Has the central bank changed its understanding of the processes that cause inflation – based, by the way, on very little new information? Has he changed the way he balances his dual mandate – that is, is he now more concerned with reducing inflation than maintaining high employment? (If so, why?) Has it changed the time frame over which it proposes to bring inflation under control, or the projected policy rates needed to bring inflation down as originally expected, or both?

The answer to all these questions is, who knows? And it’s almost absurd that choosing between 50 and 75 basis points increases them in the first place. On its own, that should tell the Fed that its message is failing — and make a tough job that much harder.

Current monetary policy has to deal with two fundamental problems. The first is a series of supply shocks of unprecedented magnitude and complexity. The other is a legacy policy framework that was (arguably) well suited to persistently below-target inflation, but is ill-suited to these new conditions.

If inflation is caused by an increase in demand, a reduction in demand is the right remedy; insofar as it is caused by sudden and temporary supply restrictions, reducing demand is a mistake. To compound this difficulty, the Fed is still harnessed to a “forward guidance” model that draws attention to the future path of interest rates more than the future path of demand. This made sense when the key rate was zero and needed to come down further, because the Fed believed that promising a “lower for longer” was the best it could do. This “zero lower bound” no longer applies. Yet the Fed is still in forward-looking mode, tightening policy by an additional quarter point and telling markets to examine the projected path of rates over the coming year – while stressing the need to watch the data and reserving the right to rotate without notice if necessary.

Well, which one is it? Monetary policy is complicated, but it doesn’t need to be so adversarial. The remedy for both of these problems – the outsized role of supply shocks and the confusion surrounding forward directions – 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 temporarily overshoot the target when supply conditions deteriorate. Moreover, it distracts from the expected path of interest rates. Meeting after meeting, the question for Fed policymakers will be: what should the interest rate be now, not six months or a year from now, to push forecast demand on track?

It’s a difficult question, of course. And the answer will change as the data comes in. It bears repeating: nothing can make monetary policy easy. But there would be less confusion, less attention to things that don’t matter, and less lag in policy adjustment if the Fed stopped organizing its announcements around a projected path for its policy rate.

Things can change suddenly. The Fed cannot say what the appropriate interest rate will be over the next two years. And if the demand outlook were to change sharply, in either direction, the interest rate would also change sharply. On Wednesday, Chairman Jerome Powell rightly emphasized the need to stay nimble. Forward guidance on interest rates is the opposite of agile. The Fed’s approach to messaging needs to change.

More from Bloomberg Opinion:

• Federal Reserve must do more than raise rates by 75 points: Mohamed A. El-Erian

• Powell’s late start on dilemma-fueled inflation traps: Jonathan Levin

• ECB delay portends bigger rate hikes in coming months: Marcus Ashworth

• Central bankers don’t know how to fight inflation: Mark Gilbert

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Clive Crook is a Bloomberg Opinion columnist and editorial board member covering the economy. Previously, he was associate editor of The Economist and chief Washington commentator for the Financial Times.

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