Don’t Expect Clairvoyance From the Federal Reserve

Don’t Expect Clairvoyance From the Federal Reserve

Life isn’t getting easier for the Federal Reserve. U.S. inflation remains way above target, supply blockages show no sign of easing, the labor market is stretched — and the pressure on prices continues to build. Many investors are expecting a faster pace of tightening from the Fed; but overdoing it risks pushing the economy into recession. Striking the right balance in monetary policy has rarely looked so difficult.

A consensus is emerging that the Fed will have to tighten more forcefully. Hawks on its policy-making committee are being heard more attentively and officials who’ve taken a softer line up to now seem to be coming round. It’s acknowledged that critics such as Harvard’s Larry Summers, who’ve been warning about persistent inflation for months, were right. Even so, the risk that too much tightening might crush the expansion hasn’t gone away.   

In wrestling with this dilemma, the main thing is for the Fed to focus on essentials — and for everybody else to stop believing that the central bank can anticipate what the future holds.

The level of demand in the U.S. currently exceeds the country’s productive capacity. This requires the Fed to reduce demand by raising interest rates — an adjustment that should happen as quickly as possible without shocking financial markets. Investor expectations have shifted, allowing a brisker pace of short-term tightening than the Fed advertised in its most recent policy announcement. The central bank has acknowledged it delayed the liftoff in interest rates longer than it would have if it had known how events would unfold. It therefore has some ground to make up.

At the same time, the Fed can’t say — and should stop pretending to know — how quickly and how far it ought to raise interest rates later this year or next. Supply-side pressures might ease in a way that makes higher demand sustainable alongside lower inflation, in which case interest rates wouldn’t need to rise as much. Or financial markets might take fright, mark asset prices sharply lower and push the economy into such an abrupt contraction that rates would need to be cut. Conceivably, a cycle of rising prices and wages might accelerate, calling for interest rates that are higher for longer.

Because the balance of future supply and demand is unknowable, it’s unwise for the central bank to base policy on forces it can’t control. The best the Fed can do is judge the current imbalance and move interest rates smoothly and firmly to correct it. Guided by its medium-term commitment to maximum employment and inflation at 2%, the central bank should stake its credibility not on a projected path of interest rates but on squaring its current policy rate with its current assessment of excess demand.

Once the limits of the Fed’s predictive powers are understood, attention could usefully turn to the contribution that other kinds of policy are making to the country’s inflation problem. The government delivered an exceptionally strong fiscal stimulus in response to the pandemic — with the benefit of hindsight, too strong. As long as the economy is grappling with excess demand, Congress should avoid making things worse with unchecked spending. Over time, policy makers can also strengthen the economy’s supply side, for instance with measures to promote immigration and ease other labor-market bottlenecks (such as those caused by unduly restrictive licensing rules).

That would take some of the pressure off monetary policy, but it wouldn’t make Chair Jerome Powell and his colleagues any more clairvoyant. Judge the next monetary-policy announcement not by what the Fed thinks could happen later this year and beyond, but by what it does about the level of demand right now.

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The Editors are members of the Bloomberg Opinion editorial board.

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