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How the Fed Can Fight Inflation & Maintain Investor Confidence

By Nick Sargen, PhD
Policy Economics
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Hourglass on US dollar banknote background. Concept world economic of time to consider raise or reduce interest rate via FED.

First, the Fed was criticized for acting too slowly to contain the spike in inflation in 2021-2022, and then many observers feared it would weaken the economy when it played catch up.

While the risk of recession has lessened, inflation has been sticky of late, and investors are questioning whether the Fed’s forecasts that call for it to approach the 2 percent target will be recognized.

Shift in Investor Perceptions

Amid these developments, investors’ perceptions about U.S. monetary policy have shifted markedly. At the start of this year, the Treasury bond market was pricing in six cuts in the Fed funds rate, or twice as many as Fed officials anticipated. For the first time since the Fed began tightening policy, investors expect fewer rate cuts than Fed officials envision.

If this disparity were to persist, it could cause investors to doubt the Fed’s commitment as an inflation fighter at some point.

Questioning the Fed's Projections

This prospect has caused the Washington Post’s editorial board to question whether Fed officials should make their interest rate projections public, considering that "Fed officials have been notoriously bad forecasters over the years."

The editorial board argues that the decision to make the "dot plot" public in January 2012 was a way for the Fed to convey to the market that it would maintain rates at a low level for a significant time after the 2008 financial crisis and Great Recession. However, with the Fed now in inflation-fighting mode and interest rates at a 20-year high, the dynamics are entirely different:

"No matter how many times Mr. Powell says that the dot plot is just a forecast and not a policy plan, the dots are being taken literally — which ties its hands," the board wrote.

Suggestions for Improved Communication

Another suggestion is that the Fed incorporate scenario analysis into its public communications.

According to a Bloomberg report, former Fed Chair Ben Bernanke has recommended that central banks publish both central and alternative scenarios so "the public will be able to draw sharper inferences about the reaction function and thus better anticipate future policy actions." The need to consider alternative scenarios is especially relevant when the economy is highly unpredictable and there is a need to convey a broader range of views.

These suggestions intend to improve the quality of the Fed’s communications with the public. However, they do not address why Fed officials significantly underestimated the acceleration of inflation that began in 2021.

Analyzing the Fed's Strategic Missteps

Economists Mickey Levy of the Hoover Institution and Charles Plosser, former president of the Federal Reserve Bank of Philadelphia, assess what happened in a presentation titled "The Fed’s Strategic Approach to Monetary Policy Needs a Reboot."

Levy and Plosser acknowledge that the Fed’s long-term strategic plan formulated in 2012 was balanced and clear. However, in the ensuing years, officials became concerned that the nominal interest rate was approaching the Fed’s effective lower bound of zero.

The reason: The Fed’s preferred measure of inflation — the personal consumption deflator — was below the 2 percent target for much of the decade, and the Fed’s estimates of the natural real interest rate showed a declining trend.

The Fed subsequently introduced the concept of flexible average inflation targeting (FAIT) in its 2019-2020 strategic review. The intent was to make up for inflation below 2 percent by aiming for it to run "moderately above 2 percent for some time." The Fed also broadened its mandate to aim for maximum employment, which meant it would try to increase the labor force participation rate while keeping unemployment low.

According to Levy and Plosser, these strategic changes contributed to the Fed underestimating the risk of inflation and failing to raise interest rates when inflation expectations became unanchored. The Fed’s reliance on forward guidance (via the dot plots) without raising interest rates, in turn, increased inflationary expectations.

Recommendations

One of their recommendations for the upcoming strategy review is that the Fed should correct the asymmetries and complexity of the flexible average inflation targeting and return to a clear 2 percent target. Another is to thoroughly review the inflation process and dynamics in light of the inadequacies of the current time-variant Phillips Curve approach.

They also believe that Fed decision-making has become too discretionary and that it should incorporate systemic rules such as the Taylor Rule as guides to policymaking.

My opinion is that one of the Fed’s greatest achievements was reestablishing its credibility as an inflation fighter during Paul Volcker’s tenure as Fed chair and maintaining it over the next four decades. The spike in inflation in 2021-2022 represented the first test of the Fed’s commitment.

Finish the Job

Unfortunately, the Fed was predisposed to make job creation its top priority even as the economy rebounded when businesses and schools reopened, and fiscal policy turned highly expansionary.

The Fed mistakenly adopted the same policy response to the pandemic as it did to the 2008 financial crisis, even though they were very different types of shocks.

With inflation currently running above 3 percent, the Fed’s principal goal today should be to finish the job and ensure that inflation returns to its stated target.

In a recent debate, two prominent economists, Glenn Hubbard and Lawrence Summers, agreed that the Fed faces a considerable challenge getting there. But this is not merely a fanciful wish of economists. It is also what the American public has been clamoring about for the past three years.


A version of this article was posted to TheHill.com on June 7, 2024.

nick sargen

Nick Sargen, PhD

Senior Economic Advisor
Nick is an international economist, global money manager, author, and contributor on television business news programs. He earned a PhD and MA from Stanford University and BA from UC, Berkeley.
IMPORTANT DISCLOSURES
This publication contains the current opinions of the author but not necessarily those of Fort Washington Investment Advisors, Inc. Such opinions are subject to change without notice. This publication has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Information and statistics contained herein have been obtained from sources believed to be reliable and are accurate to the best of our knowledge. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission of Fort Washington Investment Advisors, Inc. Past performance is not indicative of future results.

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