What Should the Fed Do?
Some thoughts for both sides
Monetary policy is extremely difficult to get right over sustained periods of time.
For starters, the central bank’s instruments “work” through their impact on the financial system, but those instruments don’t affect the financial system in consistent and predictable ways. Not all interest rate increases (or decreases) are equal. A whole range of underlying conditions—from the leverage levels of banks to the priorities of regulators to the psychology of macro traders—affects how tweaks to the level of short-term interest rates or the amount of bonds being bought each month flow through to lending standards, asset prices, and credit spreads.
But even if that weren’t an issue, the translation of broader financial conditions into actual decisions about spending, borrowing, and saving by consumers and businesses depends on a range of factors that can change over time in unpredictable ways. The boom in U.S. house prices in the 2000s had a very different impact on consumer spending than the boom since 2013, just as the high levels of oil prices in 2010-2014 and 2017-2018 had a very different impact on the behavior of shale drillers compared to 2021-2022.
Suppose, however, that central bankers were able to overcome these monumental challenges, and could justifiably claim that they knew in advance how any given policy choice would affect real economic activity. Getting things right would still require knowing what monetary policy is “best” for the economy at any given point in time, which isn’t really possible without something close to clairvoyance about how the future would unfold under different scenarios.
Given all this, I generally try to avoid specific recommendations about whether (or how much) central banks should adjust the settings on their main policy tools. My only consistent suggestions to policymakers are: take seriously what market prices are implying about future growth and inflation; and maintain flexibility by being willing to reverse course sharply. Mistakes are inevitable, but quick responses can limit their cost.
We saw the benefits of my preferred approach in 2018-2019. At first, the Federal Reserve tightened more than was necessary—and planned to keep raising short rates much higher. But then key officials changed their mind in response to movements in stock, bond, and commodity markets, eventually giving us the “mid-cycle adjustment”.1
With all of these caveats out of the way, what should the Fed do now? I don’t have a specific answer, but I thought I’d provide some thoughts and context on the best arguments in favor of “removing accommodation” (tightening, to a normal person) vs. holding steady.