The Fed Should Prepare Markets For The Unexpected

What if the US economy defies the Federal Reserve’s expectations? How will the Fed react if growth proves much slower, or inflation much higher, or both?

To an unusual extent, the world’s most powerful central bank leaves the public in the dark about such contingencies. It can and should do better.

Four times a year, the Fed releases a document called the Summary of Economic Projections, or SEP, in which the 19 members of the policy-making Federal Open Market Committee offer their forecasts for growth, unemployment, inflation and the appropriate path of short-term interest rates – in the next few years and the longer run. Markets and the media tend to focus on the medians as indicators of what Fed officials expect to happen.

Former Fed Chair Ben Bernanke thinks this isn’t good enough. At a recent research conference in Washington, he said that the Fed’s staff — the economists who provide analysis to the FOMC’s members — should publish quarterly monetary policy reports similar to those that the European Central Bank, the Bank of England and several others do. These go much further than the discussion of economic and financial developments that Chair Jerome Powell typically provides. They provide a coherent economic forecast along with alternative scenarios — an approach that, as Bernanke put it, “emphasizes the inherent uncertainty about the outlook” and offers valuable information about how the central bank would react.

Bernanke posited that the multiple scenarios would afford the Fed greater flexibility, allowing it to adjust more quickly if developments diverged from the central forecast. Suppose, for example, the Fed had laid out in 2021 what it would do if inflation proved to be higher and more persistent than expected. The advance warning would have made it easier to change course when that situation occurred, without unduly shocking the market or appearing to have reneged on the SEP interest-rate path.

Not everyone was persuaded. Bill English, the former head of monetary policy affairs at the Fed, argued that simultaneously publishing two forecasts — from the FOMC and the staff — would create confusion, and that the public might pay as little attention to the staff’s alternative scenarios as they do to the risks and uncertainty component of the FOMC projections. Also, he noted, the staff doesn’t set monetary policy, so its report wouldn’t shed much light on the Fed’s reaction function. He went so far as to quote an FOMC meeting in which I observed that markets care much more about the views of the policy makers than the views of the staff.

I’m with Bernanke on this one. The Fed’s approach falls far short of other central banks. It focuses too much attention on the FOMC’s median projections – which, as Bernanke noted, are “the median of the average of the mode,” and hence hardly the best way to communicate the Fed’s expectations and intentions. One can’t even discern the FOMC’s monetary policy reaction function from 19 individual projections of how the economy and interest rates should develop. This matters, because if financial markets can anticipate what the Fed will do, they’ll adjust faster and thus make monetary policy more effective.

Central banks with far fewer resources than the Fed manage to publish monetary policy reports, which markets participants value greatly. In my experience, the Fed staff’s forecasts carry significant weight, strongly influencing FOMC members’ projections.

To be sure, we all agree that the ideal would be a consensus forecast and alternative scenarios from the FOMC members themselves. Problem is, such a process seems impractical given the large number and geographical dispersion of FOMC participants — and would almost necessarily be centralized in Washington, making it less attractive to many of the regional Federal Reserve Bank presidents. This is one reason Bernanke’s efforts to develop a monetary policy report in 2012 faltered.

Still, second best is better than the status quo. I expect Chair Powell to propose a staff forecast with scenarios later this year. Given the complexities involved, it might not come to fruition before the end of his term in May 2026. But that’s no reason to delay. The Fed is behind its peers. Let’s get on with it.