Federal Reserve chair Jerome Powell steps down this month after proving himself an exemplary public servant. Compelled to deal with a president intent on telling the central bank what to do, his response was exactly right. Reluctant to confront the White House until he had no choice, he then did so firmly, without needless drama or any trace of ego. For the moment, the US still has an independent central bank.
As its leadership changes, its independence cannot be taken for granted — but Powell did as much as anyone could and deserves the country’s thanks.
Sad to say, the central bank’s record on monetary policy is less impressive. Today inflation is running at nearly 4% and has exceeded the Fed’s 2% target since 2021 — the worst overshoot for 40 years. The blame for this mostly lies elsewhere, but monetary policy is implicated. At the time, given incredibly testing circumstances, its errors were defensible. But it’s harder for the Fed to explain why, even now, those errors still haven’t been fully corrected.
Most critics say the Fed’s biggest mistake was to see the post-pandemic spike in inflation as self-correcting or “transitory.” The central bank cut its policy rate to zero at the outset of the pandemic and left it there for close to two years, until long after output had bounced back and the economy had returned to full employment. By the summer of 2022 the inflation rate was more than 8% and the policy rate, which the Fed had only just begun to lift above zero, was still less than 2%.
The Fed did keep interest rates too low for too long — but the question is why. Remember that the shocks kept on coming and with them, more uncertainty. With supply still constricted, raising questions about the reliability of unemployment as a measure of economic slack, fiscal policy kept piling on demand. Then Russia invaded Ukraine in early 2022, causing a spike in energy costs. More recently, Trump’s tariffs and the war with Iran pushed inflation up again. Managing monetary policy through such turbulence is extraordinarily difficult, and at every stage the central bank had a reasonable case for doing what it did.
Then where did it go wrong? It adopted and institutionalized a bias against raising the policy rate. Here too, Powell and his colleagues had their reasons. But this deliberate asymmetry went too far and hasn’t yet been properly reset.
In 2020 the Fed released a new policy framework that made the pro-inflation bias explicit. It described an approach called FAIT — “Flexible Average Inflation Targeting.” The idea was that if inflation runs persistently below 2% a year, the Fed would aim to keep it above 2% for some unspecified time in order to restore an average of 2%.
Little thought was given to whether the FAIT logic required periods of overshooting inflation to be followed by offsetting periods of undershooting. (Without such an understanding, overshoots would outweigh undershoots, and the long-term average would be more than 2%.) That question didn’t arise: The new framework followed the post-crash era of very low inflation with a policy rate cut all the way to zero. FAIT was meant to ensure that a stalled economy would expect higher inflation in due course even though interest rates couldn’t be cut any further — in effect, delivering additional monetary stimulus through “forward guidance.”
Last year the Fed finally acknowledged that dealing with the policy rate’s zero lower bound was no longer the issue. It announced a new framework emphasizing “balance” not asymmetry. It deleted the A in FAIT, dropping the promise to hold inflation above target. It also cut the term “shortfalls” from its discussion of “maximum employment” and replaced it with “deviations” — to avoid the implication that a weak jobs market would weigh more in its decisions than an overheated jobs market.
As well as coming too late, this rethink didn’t go far enough. The Fed is still muddled over what role, if any, forward guidance should play, aside from affirming the central bank’s commitment to its dual mandate of price stability and maximum employment. The legacy of FAIT and forward guidance lingers in the way the central bank describes the outlook for the economy and what it sees as the “appropriate” future path for the policy rate, which it sets out periodically in its Summary of Economic Projections, or “dot plot.”
A device used by no other big central bank, the dot plot is especially nonsensical. First, it creates an expectation for a future path of interest rates — which is unwarranted, and typically counter-productive, when the economy is neither at or close to the zero lower bound. Second, it makes the Fed’s policymakers feel at least somewhat obliged to deliver said rate adjustments, even as conditions and judgements shift. Third, the information it delivers is incoherent: There’s no way to disentangle each policymaker’s choice of appropriate future rate from his or her judgements about the expected and appropriate paths of output and inflation, or the trade-offs demanded by the dual mandate. When conditions change, as they’re bound to, the dot plot therefore tells you nothing about how the appropriate interest rate might shift.
These defects are even more telling when, as now, exceptional and unprecedented shocks buffet the economy. Any policy framework that inhibits the Fed from adjusting policy as conditions dictate is unhelpful. In effect, the choice is between forward guidance and data dependence: The current framework aims for both, which doesn’t work. The problem is not that the Fed gives out too much information — you can’t have too much information — but that the information is much less useful than it should be. The Fed ought to follow the approach of other central banks and publish a staff forecast using market expectations to drive the forecast interest rate, with alternative scenarios and/or “fan charts” to underline the uncertainties. That would convey more and better information while allowing more freedom to adjust the policy rate as the data comes in.
Powell’s successor Kevin Warsh will have many other issues to address: relations between the Fed and the Treasury, appropriate use of the central bank’s balance sheet, the best way to structure bank reserves, not to mention further pressure from the White House. But changing the way the Fed explains itself is crucial for more effective monetary policy. It should be up there with central-bank independence at the top of his list.
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