The Federal Reserve has begun one of its reviews of “monetary policy strategy, tools and communications.” This month’s cut in interest rates and investors’ reaction to it underline just why such a review is needed.
Consider how the latest policy announcement unfolded. It had three main parts. First, the Fed cut 25 basis points from the policy rate, bringing it down to a range of 4.25%-4.5%. Second, it said progress in curbing inflation was going more slowly than expected. Third, it projected fewer rate cuts next year than it did previously. Investors saw this combination as a “hawkish pivot” – meaning a tightening of policy despite the rate cut – and dumped shares.
It seems we have a failure to communicate. Much as I admire Fed Chairman Jerome Powell and his colleagues – the “soft landing” they hoped to engineer has been going well – the way the Fed signals and executes changes in policy is making an already difficult job harder than it needs to be.
Before the policy meeting, financial markets had firmly priced in the quarter-point cut, in large part because the Fed’s earlier messaging had encouraged them to do so. Investors therefore gave less weight to recent data pointing to slower-than-expected progress on inflation. For the year just ending, the Fed’s new summary of economic projections was about to show core PCE inflation (the central bank’s preferred gauge) of 2.8%, not 2.6% as in the previous summary; lower unemployment (4.2% in the new summary, down from 4.4%); and faster economic growth (2.5% not 2.0%). As my Bloomberg Economics colleague Anna Wong noted shortly before the policy announcement:
Given those expected revisions, an inertial Taylor Rule would recommend holding rates steady at the December FOMC rather than cutting. One reason we think the Fed may still act is that with the markets already pricing in a cut, pausing would mean effectively raising rates.
For the uninitiated, an inertial Taylor Rule is a formula for setting the policy rate according to shifting data on inflation and output – specifically, the gaps between (a) actual and target inflation and (b) actual and potential GDP. (The “inertial” form of the rule includes a term that adjusts the policy rate gradually rather than all at once.) Economists have long split over the pros and cons of using some such rule to set policy automatically, but most think it should be part of the discussion about how to set the rate.
Before the meeting, the data had changed in a way that said, pause. In the press conference following the announcement, Powell was asked why the Fed had cut anyway. His answers weren’t very illuminating. The Fed wanted to get the policy rate a bit closer to the so-called neutral rate that neither restricts not stimulates demand, he said. But his answer begs the question: If inflation might be stabilizing above the 2% target, why assume that the policy rate was too restrictive? When asked for his current estimate of the neutral rate, the chairman laughed and said, in effect, nobody knows.
The Fed is presumably expecting future numbers on inflation and employment to move back toward the desired path. Why not wait for that to happen? Meantime, the new summary of projections, which takes account of the latest rate cut and the (now fewer) cuts projected for next year, shows core PCE inflation at 2.5% a year from now, not 2.2% as before, and 2.2% two years from now, not 2%.
I think my colleague read the Fed’s calculation exactly right: Given the markets’ expectation, leaving rates unchanged would have amounted, in effect, to a tightening – and while the Fed might have preferred a pause, it thinks tightening at the moment would be unwise.
What a tangle. The implication is that if investors hadn’t priced in a cut, the Fed would have left the policy rate unchanged – and hence better aligned with the latest data. But why did investors price in a cut not aligned with the latest data? At least partly because they paid too much attention to the Fed’s previous summary of projections, which had trailed one more cut by year’s end.
This same muddle now carries forward. The new projections tell investors to expect a policy rate of 3.9% at the end of 2025, not 3.4%. Set aside that this “hawkish” switch unsettled investors despite the Fed’s reluctance to spring surprises. More important, as fresh information arrives, this latest policy projection might well clash in due course with Taylor Rule-type recommendations just as the previous one did, and again deflect the Fed from doing what it thinks the data suggest – from cutting the rate faster or pushing it back up, as the case may be.
For sure, it’s good to have investors’ expectations aligned with what the Fed intends to do, But markets and central bank alike should be concentrating on incoming data and what the data mean for policy, rather than dwelling on what the Fed previously thought it might do on the basis of information that’s now out of date.
One way to push in this direction would be to reform the summary of economic projections, including by scrapping the “dot plot” of future interest rates. This latter device begs to be misunderstood. The Fed finds it necessary to insist, again and again, that the dot plot isn’t a plan or a promise, just a projection. In fact, it isn’t even a projection in the usual sense, because it doesn’t express a consensus: It sets out what individual officials think might be “appropriate” on the basis of their differing, possibly incompatible beliefs about what will happen.
Strict adherence to a policy rule, however well designed, is probably not the best way to align expectations with new data because complications and exceptions would frequently arise. But short of that, the Fed could definitely give more weight in its messaging to Taylor Rule-type calculations based on inflation and output gaps, or on the path of aggregate demand as given by nominal GDP. This second method in effect merges the inflation and output gaps, underlining that the policy rate influences overall demand rather than separately driving inflation and real output. There’s a lot to be said for it, and I’ll come back to this another time.
However it’s done, the main thing is to focus attention more tightly on incoming data and not on plans and promises about the path of interest rates that aren’t actually plans, promises or even coherent consensus forecasts. If the policy review moves the Fed a step or two in this direction – and especially if it dumps the damn dot plot – it will have served a useful purpose.
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