The Federal Open Market Committee hiked interest rates 75 basis points Wednesday, as expected, and markets clearly agreed. Nearby are some cautionary tales of inflation. But we were also impressed that Chairman Jerome Powell appeared to take a step to reverse the Fed’s misguided policy of forward guidance.
“We think it’s time to just go from meeting to meeting,” Mr. Powell said in his press briefing, “rather than giving the kind of clear guidance that we had given” on future Fed policy. That was good to hear as the Fed’s relatively new practice of saying its policy in the months and even years to come has proved embarrassing.
The theory behind forward guidance is that central bankers can guide long-term interest rates and other market decisions by signaling the central bank’s intentions and explaining its view of the economy. Proponents believe this is especially important when short-term interest rates are so low that the central bank needs to find new tools to steer the economy. It is said that clear statements about the future development of short-term interest rates and measures such as bond purchases can influence longer-term interest rates.
This practice is so widespread that it’s easy to forget how anomalous it is. For most of its history, the Fed has communicated little about its decisions to raise or lower short-term interest rates, let alone anything else.
Chairmen William McChesney Martin, Arthur Burns and Paul Volcker have almost always kept a low profile on future policy. That began to change under Alan Greenspan, when he discussed in post-meeting statements whether the FOMC thought the “balance of risks” pointed to future rate cuts or hikes.
Forward guidance peaked after the 2008 financial panic. The Fed and other central banks have come to believe that they need to explicitly manage longer-term and short-term interest rates. The announcement of the future policy should also reduce market turbulence.
Forward guidance comes in many guises: press conferences, speeches, or the Fed’s Quarterly Economic Forecast Summary, which has those infamous scatter plots of individual FOMC members’ rate forecasts. The Powell Fed also loves strategic media leaks before each FOMC meeting.
The problem is that forward guidance is proving to be a political failure. The first post-crisis turmoil came under Chairman Ben Bernanke in 2013, when a botched attempt to explain the Fed’s intention to scale back asset purchases triggered more market volatility — the so-called taper tantrum — rather than less.
More recently, Mr. Powell was so cautious about repeating this episode that he made the opposite mistake: He warned investors so much about the lifting of pandemic stimulus that he delayed monetary tightening for months as inflation picked up steam . In both cases, the underlying error was a refusal to let the market assess new information and price risk, even though this process can be volatile.
At the same time, forward guidance has become a major threat to the Fed’s credibility. Consider these scatter plots. These are accounted for as “projections” of future interest rate movements in line with estimated future GDP, employment and inflation. But these forecasts are a lagging indicator as they follow economic data that is already clear to markets and highlight just how unreliable the Fed’s economic understanding is.
Markets would provide wiser estimates, apart from the fact that the Fed has trained investors to bet on Fed guidance rather than economic variables.
The alternative is to let markets be markets again. The European Central Bank could lead the way. Last week it dropped forward guidance on short-term interest rates (although it still offers guidance on its plans for its bond portfolio). The bank sets the rates session by session according to economic conditions.
Mr Powell was more confusing than the ECB on Wednesday. He promised session-to-session judgments, but also spoke too much about what the FOMC interest rate peak might be in this tightening cycle. “As monetary policy tightens further, it will likely become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments affect the economy,” he said. Sure, and maybe not.
Ultimately, what the Fed does, not what its chairman says, is what matters to the markets and the course of inflation. After its historic inflation blunder in 2020-2021, the Fed needs to restore its honest fight against inflation. Ending the Forward Guidance would be a political step forward.
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Appeared in the July 28, 2022 print edition as “Goodbye Fed Guidance? Let’s hope.’
https://www.wsj.com/articles/goodbye-fed-guidance-let-us-hope-jerome-powell-federal-reserve-inflation-monetary-policy-11658955848 Goodbye Fed Forward Guidance? Let Us Hope