A farewell to forward guidance at the Fed
There has been a sea change in central banking that many have failed to grasp.
Edward Price
US monetary policy is accommodative — it has been for years.
But, just as loose conditions are becoming easier to anticipate, policy itself is becoming harder to predict.
This has left traders on edge, with the Treasury market gyrating as they try to bet when the Fed will tighten.
One cause of that uncertainty is the Federal Reserve’s new approach to monetary policy.
The approach’s cornerstone, unveiled last summer, is Flexible Average Inflation Targeting, or FAIT.
It goes a little something like this.
The Fed will pursue modest, but undefined, periods of inflation above its 2 per cent target (which it has failed to hit for a number of years).
This aims to bring the average of any two periods up to, and anchor expectations at, 2 per cent.
If the first period sees inflation below 2 per cent, and in the second period above, then inflation is actually at — wait for it — 2 per cent.
Abracadabra.
It’s obvious why the Fed would seek an approach that gives it more headroom to target higher inflation.
Having saved capital markets from a pandemic-related meltdown in 2020, it’s now attempting to support a deeply troubled US labour market in order to fulfil its commitment to maximum employment.
That’s all to the good.
The pandemic has spurred talk of the K-shaped American recovery that exacerbates economic inequality.
However, it’s not actually clear for how long the Fed will run the engine hot.
When pushed, the Fed’s response is something like ‘for a sustained period’.
In other words: we don’t know and neither do you.
We are in uncharted territory here.
While several central banks target inflation of 2 per cent, the Fed is the first major central bank to explicitly state that it wants to see a period of above-target inflation before tightening monetary policy.
This is perhaps hyperbolic, but it appears FAIT has ended forward guidance as we know it and marks the end of an era of ever-greater central bank openness.
Over recent decades, central bankers have become less and less ambiguous about where they see monetary policy heading.
The idea behind this more open style of communication is that signalling what you want to do bolsters the effectiveness of what you actually do before you do it.
The idea has taken off to the extent that the term forward guidance has become commonplace among central bankers.
Yet FAIT goes in the opposite direction.
Instead of injecting greater certainty, the new approach introduces a significant degree of uncertainty into the central bank’s future conduct.
The idea is akin to doublethink.
If successful, inflation will be static, at 2 per cent.
But only because it’s dynamic and above 2 per cent for a period.
This is a contradiction. And it’s probably too subtle for the labour market to grasp.
That matters because, if workers and other economic actors don’t adjust their expectations and act as though inflation will be above 2 per cent for a while, then it becomes less likely that the Fed will succeed with FAIT.
The role of expectations goes some way to explaining why the Fed’s ambiguity is constructive.
What happens to inflation is not solely down to external forces — it is influenced by guesses as to the Fed’s tolerance for price pressures is too.
If the Fed was explicit that it would tolerate a “sustained period” of, say, 2.5 per cent inflation, then the risk is that this would become entrenched and people would expect inflation to average that amount over a longer time horizon than policymakers might like.
As much as FAIT produces uncertainty, it is also a product of uncertainty.
For a while now, central bankers have admitted they can’t really measure the economy.
Jerome Powell in Jackson Hole in 2018 spoke about how the stars — shorthand for policymakers’ estimates of the natural rates of inflation, unemployment and interest rates — are shifting all over the place.
He’s right. We can’t measure everything we want to measure.
Nowhere is this more so than in the labour market, where recent periods of low unemployment have failed to produce the price pressures that economists would usually expect, leading the Fed to persistently undershoot its 2 per cent goal.
And so, unable to judge the trade-off between jobs and price pressures, we can’t be overly mechanistic in the way we set monetary policy.
Since the global financial crisis, and during the pandemic, this truth has become ever clearer.
In a possibilistic world, a reliance on probabilistic reasoning eventually backfires.
Of course, the Fed is not entirely letting go of clarity.
Their forecasts are clear as to their expectations to leave rates on hold throughout 2023.
And the Fed is nothing if not open about FAIT itself.
But explaining the framework again and again, as Jerome Powell and others have done, doesn’t reduce the injection of uncertainty.
If anything, it just provides forward guidance about the dilution, even end, of forward guidance itself.
In times as strange as these, let’s just be thankful the American central bank is smart enough to deal in ambiguities.
That might mean waving goodbye to forward guidance and embracing the weird, but the world is in flux and anything less agile than FAIT could become an implausible commitment.
Edward Price is a former British economic official and current teacher of political economy at New York University's Center for Global Affairs. In this post, he sets out why the Federal Reserve’s new framework marks a break with the trend towards more certainty in central banking.
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