The Fed Should Stop Confusing Investors

(Bloomberg Opinion) -- The Federal Reserve surprised nobody when it raised its policy rate 75 basis points on Wednesday. Attention had already switched to what happens next. Will the pace of tightening slow from now on? Is the Fed changing its mind about how high rates will need to go? Despite Chairman Jerome Powell's efforts to address those questions, his answers leave plenty of doubt. And that's a problem.

To be clear, the Fed's future interest-rate decisions need to be data-dependent, as Powell insists. If monetary policy is hard to predict merely because the future is uncertain, that's fine. The trouble is, uncertainty isn't confined at present to doubts about how the economy will evolve. What's also unclear is how the Fed will respond to changing conditions.

Investors are understandably confused. Most expect a gentler path for rate increases going forward, leading to a “terminal rate” of roughly 5% next year. But the right question isn't whether this is what the Fed has in mind; it's what the Fed would do if things turn out differently than it expects. Suppose, for example, that unemployment rises abruptly but underlying inflation fails to subside. Would that mean higher rates, lower rates or keeping things the same? At the moment, it's hard to say.

The Fed has a policy framework that's meant to shed light on such judgments. Unfortunately, it's now largely irrelevant.

In 2020, after a painstaking review, the central bank switched to an approach called flexible average inflation targeting. This assumed that fighting inflation was yesterday's war. It emphasized “forward guidance” and the need to keep rates lower for longer. Instead of trying to anticipate a rise in prices, officials would wait until it happened. Regarding the second part of the Fed's “dual mandate,” policy would aim for “maximum employment,” not “full employment” (that is, the highest employment consistent with stable prices). This too suggested that the Fed would err on the side of running the economy hot.

The timing was terrible — but don't blame the Fed for failing to foresee the pandemic, or Russia's invasion of Ukraine and subsequent disruption of energy supplies. These enormous supply-side shocks stunned policymakers everywhere. Also, give Powell and his colleagues credit for agreeing that they were too slow to start raising rates when inflation picked up. That frank admission strengthened confidence that the central bank is determined to get inflation back under control. For the moment, the Fed's credibility is still strong: Witness the stability of inflation expectations despite the shocking pace of recent price increases.

Maintaining that credibility is crucial — but it can't be taken for granted. By now the Fed has tacitly discarded much of the 2020 framework, but this leaves a vacuum. To narrow the scope of avoidable uncertainty, a more thorough and deliberate revision is needed.

At a minimum, the new framework should look skeptically at forward guidance and other aspects of the Fed's recent communications, revisit the question of monetary policy at the “zero lower bound,” restore the goal of heading off inflation before it happens, rehabilitate “full employment,” explicitly state the indicators that guide interest-rate decisions, and above all clarify the appropriate policy response to shocks in supply as opposed to demand.

That's a lot to be getting on with. Yet without a fresh look at these issues, investors will continue to ask the wrong questions and be frustrated by the Fed's unhelpful answers.

More From Bloomberg Opinion:

• Taming Inflation Is Only Half the Fed's Battle: Conor Sen
• The Fed Has a Secret Weapon in Households: Karl W. Smith
• The Path to a Soft Landing Runs Through Earnings: Jonathan Levin

The Editors are members of the Bloomberg Opinion editorial board.

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