Uncertainty at the Fed

In public statements, officials have given some hints as to what these other considerations may be. They seem to include the risk of distortion in the financial system, worries that unemployment may fall to unsustainable lows, and concerns that raising interest rates too quickly will disrupt economic recovery. But the fact remains that the Fed’s criteria for changing interest rates are for the most part unstated and unclear, making it difficult to predict how it will act.

“This kind of uncertainty – about which goals will define the Fed’s policies – is not healthy,” says Kocherlakota. “Consumers and businesses can’t make good decisions if they don’t have a strong enough sense of how the central bank will act in any situation.”

Kocherlakota is right to be concerned. If anything, he understates the problem. A lack of clarity about the Fed’s economic objectives is just one factor obscuring understanding of its decision-making.

The heart of the trouble consists in the fact that neither financial-market participants nor, it seems, the Fed itself know the true state of the economy or how best to model it – especially in the wake of the 2008 financial crisis. And it remains unclear how the Fed is using new data to update its analysis.

The confusion about which factors – besides price stability and maximum feasible employment – the Fed takes into consideration in setting monetary policy aggravates the problem. It has

become nearly impossible to predict how the Fed will respond to events.

In an environment of economic volatility like the one in which we find ourselves today, a prudent central bank should do everything it can to raise expected and actual inflation, in order to gain the ability to stabilize the economy in any direction. If interest rates were well above zero, the Fed would have scope to raise them further in case of overheating or to lower them in response to adverse demand shocks.

But the Fed is not pushing for inflation at or above its target. Instead, by tightening policy, it is narrowing its room for maneuver – and is champing at the bit to narrow it even more.

Nor does the Fed seem to be updating its view of the economy in an understandable way. In June 2013, the Fed was predicting that annual GDP growth during the 2013-2015 period would average 2.9%, with longer-run growth of real potential GDP averaging 2.4%. Instead, annual growth has averaged 2.3% (or 2.2%, if estimates for the first half of 2016 are correct).

Nor did it perform better on other measures. The Fed predicted an annual inflation rate, based on the personal consumption expenditures index, of 1.9% for 2015. The true number was 1.5%. Similarly, its average projection of the federal funds rate for 2015 was 1.5%. The figure is currently 0.25%.

This three-year period, starting in 2013, in which the economy undershot the Fed’s expectations, follows a three-year period in which the economy likewise fell short of the Fed’s forecast. And that period followed a three-year period, starting in 2007, in which the Fed massively understated downside deflationary risks.

One would think that such a track record would have prompted officials to revise their model of the economy. But the Fed continues to neglect asymmetry, considering it only a second- or third-order phenomenon. It continues to gear inflation expectations at unrealistically high levels based on past inflation. And it continues to rely on the unemployment rate as a stand-in for the state of the labor market, at the expense of other indicators.

The Fed has also been consistently more optimistic than market expectations about the available headroom for raising interest rates. This had led observers to conclude that Fed officials have not just been unlucky; they have an incorrect understanding of the economy. Indeed, the failure of officials to convey how their inability to make accurate predictions has prompted them to update their model is leading many to lose confidence in the Fed’s capacity for sound decision-making.

If the Fed is to maintain the confidence of markets, it will need not only to communicate its key objectives; it will also have to make clear which considerations have priority and how officials will respond if policy prescriptions required to meet various objectives conflict with one another. Finally – and most important – the Fed will have to provide reassurance that it is keeping its internal model of the economy up to date.

J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research. 

By J. Bradford DeLong