Opinion | Goodbye Fed Forward Guidance? Let Us Hope

Federal Reserve Board Chairman Jerome Powell departs a news conference on July 27.



Photo:

jim lo scalzo/Shutterstock

The Federal Open Market Committee raised interest rates by 75 basis points as expected Wednesday, and markets clearly approved. See nearby for some cautionary inflation notes. But we were also struck that Chairman

Jerome Powell

seemed to take a step toward cashiering the Fed’s misguided policy of “forward guidance.”

“We think it’s time to just go to a meeting-by-meeting basis,” Mr. Powell said in his press conference, “and not provide the kind of clear guidance that we had provided” on future Fed policy. That was good to hear, since the Fed’s relatively recent practice of saying what its policy will be in the months and even years ahead has turned out to be embarrassing.

The theory behind forward guidance is that by signaling the central bank’s intentions, and explaining their view of the economy, central bankers can guide long-term interest rates and other market decisions. Proponents believe this is especially important when short-term rates are so low that the central bank must find new tools to steer the economy. Clear statements about the future path of short-term rates and policies such as bond purchases can direct longer-term rates, the argument goes.

This practice has become so common it’s easy to forget how anomalous it is. For most of its history the Fed communicated little about its decisions to raise or lower short-term rates, let alone anything else.

Chairmen

William McChesney Martin,

Arthur Burns

and

Paul Volcker

were almost always tight-lipped about future policy. This began to change under

Alan Greenspan

with language in post-meeting statements about whether the FOMC thought the “balance of risks” pointed to future rate cuts or increases.

Forward guidance reached full flower after the 2008 financial panic. The Fed and other central banks came to believe they must explicitly direct longer-term and short-term rates. Giving notice of future policy is also supposed to reduce market turbulence.

Forward guidance comes in many guises: press conferences, speeches, or the Fed’s quarterly Summary of Economic Projections, featuring those infamous dot-plots of individual FOMC members’ interest-rate predictions. The Powell Fed is also fond of strategic media leaks ahead of each FOMC meeting.

The problem is that forward guidance is proving to be a policy failure. The first postcrisis mess arrived under Chairman

Ben Bernanke

in 2013, when a bungled attempt to explain the Fed’s intention to scale back bond purchases triggered more market volatility—the so-called taper tantrum—rather than less.

More recently, Mr. Powell was so wary of repeating that episode that he made the opposite mistake: He gave investors so much warning about the removal of pandemic stimulus that he delayed policy tightening for months as inflation gathered pace. In both cases, the underlying mistake was the refusal to let the market evaluate new information and price risk, even if that process can be volatile.

Along the way, forward guidance has become a major threat to the Fed’s credibility. Consider those dot plots. These are billed as “projections” of future interest-rate moves in line with estimated future GDP, employment and inflation. But these projections are a lagging indicator, following economic data already plain to markets and highlighting how unreliable the Fed’s understanding of the economy is.

Markets would furnish smarter guesses, except for the fact that the Fed has trained investors to bet on Fed guidance rather than on economic variables.

***

The alternative is to let markets be markets again. The European Central Bank may be leading the way. Last week it abandoned forward guidance on short-term interest rates (although it is still offering guidance on its plans for its bond portfolio). The bank will set rates meeting-by-meeting in line with economic conditions.

Mr. Powell was more confusing than the ECB on Wednesday. He promised meeting-by-meeting judgments but also opined too much on what the FOMC’s interest-rate peak might be in this tightening cycle. “As the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy,” he said. Sure, and it might not.

What ultimately matters to markets, and to the course of inflation, is what the Fed does, not what its chairman says. After its historic inflation mistake in 2020-2021, the Fed needs to restore its inflation-fighting bona fides. Ending forward guidance would be a policy step forward.

Main Street: “Inflation is just like alcoholism,” said economist Milton Friedman. “In both cases…the good effects come first, the bad effects only come later.” Could there be a lesson here for Joe Biden? Images: Bettmann Archive/Getty Images Composite: Mark Kelly

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Appeared in the July 28, 2022, print edition as ‘Goodbye Fed Guidance? Let Us Hope.’