About the author: William English is a professor in the practice of finance at the Yale School of Management. He previously served as the director of the division of monetary affairs at the Federal Reserve Board.
The Federal Reserve faces two related challenges. First, how can it best calibrate the pace and extent of future rate increases, as well as the timing of any subsequent reductions in rates? And second, how ought it to communicate with the public about the outlook for policy?
Last week, the Federal Reserve increased its target for the federal funds rate by 75 basis points, bringing the total increase since March of this year to nearly 4%. At his post-meeting press conference, Fed Chair Jerome Powell noted that ongoing rate increases would remain appropriate for a while, but that the pace of policy tightening would likely slow fairly soon.
Conceptually, the Fed would like to tighten policy until it is restrictive enough to ease pressures in labor and output markets and get inflation on a path back to 2% over the medium term. But in practice, calibrating the appropriate degree of tightening is difficult, in part because of the lags with which monetary policy affects the economy. While actual and anticipated changes in monetary policy influence financial markets very rapidly, the effects of those changes in financial conditions on spending take time. Many households and businesses won’t immediately understand the changes in financial markets, and they have habits, commitments, and planning processes that slow the resulting adjustments in their spending. Moreover, some spending—say to build a factory—simply takes a long time and is costly to stop before completion. The effects on spending then influence the degree of slack in output and labor markets, which, in turn, affect inflation over time, but only as prices and wages are gradually adjusted.
As a result of these lags, policy makers need to be forward-looking, basing policy decisions on models and forecasts. But the Fed is presumably less confident of its forecasts given economists’ lack of experience with the effects of global pandemics on the economy, the difficulty of evaluating the timing and size of the effects of the unprecedented fiscal actions taken in response to the pandemic, and the outsized geopolitical risks to the economic outlook. In addition, models of the inflation process have proven unreliable over the past 18 months, with inflation running persistently above the Fed’s forecasts. These uncertainties make decisions on the calibration of policy more difficult and subject to considerable revision, as we have seen this year.
An additional complication is that the Federal Reserve, correctly, is taking a risk-management approach, aiming to balance the costs of tightening too little or too much. As Chair Powell noted in his Jackson Hole speech in August and reiterated at his press conference last week, the Fed views the costs of doing too little as considerably larger than those of doing too much. While there would be significant costs to excessive tightening, if the economy slows to an undesirable extent, policy makers can ease policy to help get the economy back on track. However, if the Fed tightens too little now, inflation will remain well above target for longer, raising the risk that excessive inflation gets built into wage and price setting behavior. The costs of entrenched high inflation would be very large: The Fed would have to tighten monetary policy substantially, potentially triggering a deep recession, to get inflation down.
That said, with the rapid adjustment in policy put in place this year, the consequent sharp tightening of financial conditions, and emerging signs that the economy is slowing, the risks are likely getting somewhat more balanced. But policy makers will need to continue to focus on the incoming data and what it says about the outlook, the risks to the outlook, and the effects of monetary policy as they judge the appropriate amount of tightening.
The complications around policy calibration contribute to the Fed’s communication challenge. For most of the past 15 years, the Fed has provided considerable information about the outlook for policy. That guidance was helpful because for much of the period, the federal funds rate was at or near its effective lower bound, and the Fed could use forward guidance about future decisions to ease financial conditions and so support growth. However, with interest rates now far from their lower bound, and given the very large uncertainties about the outlook for the economy, the Fed will soon be unable to provide significant guidance about future rate decisions. Because investors have gotten used to having strong guidance from the Fed to anchor their expectations about the future path of rates, this lack of communication could lead to uncertainty in markets, increasing asset price volatility, reducing liquidity, and widening risk spreads. These effects may be reinforced by strains in markets related to the Fed’s ongoing program of balance sheet normalization, under which markets may need to absorb as much as $95 billion of Treasury and agency mortgage backed securities each month.
As always, it will be important for the Fed to communicate as clearly as it can about the outlook for the economy and policy. However, the Fed cannot communicate what it does not know. Investors will need to adjust to an environment in which they cannot depend on the Fed for clear guidance about the future path of policy. Instead, they will have to make their own assessments of the outlook for the economy and monetary policy—and invest accordingly.
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Read More: The Fed Can’t Communicate What It Doesn’t Know