Where the Fed went wrong

In light of repeated forecasting errors, Federal Reserve (Fed) officials have been forced to frequently revise their economic projections and to radically alter their forward guidance in recent months. Importantly, monetary policy missteps were a major contributor to the emergence of a once-in-a-generation inflation shock. Consequently, the Fed has lost some credibility.

Following the Federal Open Market Committee (FOMC) meeting in May, Chairman Jerome Powell offered a clear signal that 50-basis point rate hikes should be penciled in for June and July. Yet, following a jump in consumer inflation expectations and a spike in the Consumer Price Index-based inflation rate last week, the Fed was forced to hike its policy rate by 75-basis points on June 15.

Even more awkwardly, the June 2022 Summary of Economic Projections (SEP) indicates that Fed officials have had to radically overhaul their forecasts from just three short months ago (and the March 2022 SEP itself reflected a sharp change from the December 2022 SEP). The extent of the ongoing shift in the Fed’s outlook is revealed by the fact that the median forecast in the September 2021 SEP called for just a single 25-basis point rate hike for all of 2022.

Given its stunningly poor forecasting record, the Fed needs to fundamentally rethink its approach and undertake some serious soul-searching regarding the causes of its failure. Sadly, the following quote may actually reflect the reality in economic circles: “An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.”

Developing and calibrating fanciful mathematical and statistical models to generate point estimates (that are invariably wrong) should not be the primary focus of macro analysis at central banks. In real-world policymaking, it is often better to be roughly right than precisely wrong. The Fed should hire economists with differing viewpoints and approaches and encourage open debate to avoid groupthink.

Given heightened uncertainty and rapidly evolving economic conditions, the Powell Fed would have been well-served if it had maintained some optionality and not committed early to sustaining an ultra-accommodative monetary policy stance. In hindsight, the Fed should have left the door open to initiate monetary tightening in the second half of 2021. A healthy dose of skepticism regarding forward guidance would have certainly benefited the central bank.

According to former Fed Chair Ben Bernanke, forward guidance “is central bank communication about its economic outlook and policy plans. Forward guidance helps the public understand how policymakers will respond to changes in the economic outlook and allows policymakers to commit to ‘lower-for-longer’ rate policies.” But for forward guidance to be effective, the central bank’s messaging has to be clear. Additionally, the central bank must have considerable certitude about its economic outlook before it can truly commit to medium-term guidance.

The disastrous performance of economists at the G-4 central banks and at major academic institutions in the runup to the 2007-09 global financial crisis has already been well-documented. Now the economics profession is once more facing criticism as questions are being raised about the failure to foresee the inflationary consequences associated with ultra-loose monetary policies undertaken in conjunction with extraordinary fiscal stimulus.

More broadly, the Financial Times’s Gillian Tett, channeling (the late Swedish economist) Axel Leijonhufvud, has argued that economists are prone to tunnel vision and abstraction and that the field is still dominated by “siloed thinking.” These are certainly valid and trenchant critiques of the economics field.

But not all of us suffered from tunnel vision. Besides frequently warning that the Fed may be too complacent about inflation risks, I also noted (in February 2021): “An added risk in the current cycle is that surging asset prices combined with unprecedented fiscal and monetary largesse may finally cause inflation to emerge from its long dormancy. Standard inflation measures often fail to properly account for early signs of pricing pressures. By having overcommitted to its easy policy stance, the Federal Reserve will find it hard to change direction in the future without creating significant financial market upheaval.”

Tragically, we are all now facing the consequences of past policy errors by monetary and fiscal authorities. Besides the cost-of-living crisis, a bear market in equities, a rapidly-fading housing boom and a potential deterioration in the labor market will test consumer resiliency. A U.S. recession or, at the very least, a sharp economic slowdown appears inevitable.

The promise of a more aggressive monetary tightening schedule indicates that the Fed is finally getting serious about tackling runaway inflation. If the Fed does indeed push policy rates to the projected terminal rate range of 3.75-4.00 percent by early 2023, there are likely to be some serious consequences for both asset markets and the real economy.

Investors and financial market participants need to be aware of potentially adverse shocks that may arise as credit spreads widen. The combination of quantitative tightening and rate hikes implies a rapid and sudden shift away from a dozen years of easy money policies in the advanced world. It would take a great deal of luck to avoid serious financial dislocations in the coming quarters. Recent turmoil in the crypto sector may be a harbinger of more troubles ahead. 

Reestablishing credibility and restoring price stability must be the Fed’s primary focus going forward. Given its belated response to the inflation shock, the central bank faces an unenviable task — it has to undertake aggressive monetary tightening in the face of elevated levels of financial volatility and a rapidly cooling economy.

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.