The Federal Reserve has the greatest difficulty in making accurate economic forecasts. Yet that does not stop it from nailing its colors to the mast when making policy decisions only to have to make embarrassing retreats when its forecasts turn out to be wide of the mark. Nor does it stop the Fed from being anything but humble and nimble to use Fed Chair Jerome Powell’s words.
One instance of this behavior occurred in mid-2020 when the Fed Reserve adopted its average inflation targeting framework. Fearing that inflation would stay too low for too long, the Fed indicated that henceforth it would tolerate inflation above its 2 percent target for an extended period of time.
By end-2021, the Fed had to abandon this new inflation framework. It did so when it turned out that far from remaining too low, inflation accelerated to a multi-decade high and became the nation’s number one economic problem. Inflation accelerated not least because of the Fed’s excessively easy monetary policy based on its faulty inflation forecast.
Today, the Fed seems to be making the same mistake as it made before but in the opposite direction, Desperate to regain control over inflation, the Fed is now committing itself to a prolonged period of monetary policy tightening. Not only is it signaling a series of 50 basis point hikes in its policy interest rates. It is also indicating that it will soon be reducing market liquidity by $95 billion a month by not rolling over its large bond holdings at maturity.
In a recent interview, Lael Brainard, the Fed’s dovish Vice-Chair, underlined the Fed’s newfound zeal in fighting inflation. She did so by indicating that there were no circumstances that she could reasonably foresee that would cause the Fed to deviate from its intended course to raise interest rates at each of its remaining scheduled meetings this year and to reduce the size of its balance sheet at its pre-announced pace.
How quickly Ms. Brainard seems to have forgotten the many past occasions on which Fed Reserve has been blindsided by events it clearly did not foresee. In 2008, the Fed was blindsided by a once-in-a-century housing and credit market bust. In 2020, it was taken by complete surprise by a once-in-a-century health pandemic. Last year, it was caught totally off guard by a major acceleration in inflation.
It is also striking how oddly Ms. Brainard’s seeming complacency that the Fed Reserve will manage to beat inflation and yet secure a soft economic landing sits with stark warnings of real economic trouble ahead by some of Wall Street’s heavyweights. This week, Jaime Dimon, JP Morgan’s highly respected head, recommended that we should brace ourselves for an economic hurricane in the year ahead.
One thing that Mr. Dimon might be seeing that Ms. Brainard is missing is the high likelihood that today’s overvalued equity, housing, and credit markets cannot tolerate further Fed interest rate hikes. Mr. Dimon is supported in this view by the almost 20 percent decline in the stock and credit markets since the start of the year when the Fed shifted to a more hawkish monetary policy stance.
Another thing that Mr. Dimon might be seeing that Ms. Brainard is not is the high likelihood of an external economic shock. This might take the form of the wave of emerging market debt defaults about which the World Bank is warning, a further upward movement in international oil prices due to Russian and Middle East developments, or further missteps by the Chinese government in dealing with its Covid crisis.
The moral of the story is that we now live in a world of heightened economic uncertainty. In such a world, we need a humble and nimble Fed Reserve. In particular, we need a Fed that does not keep making the same mistake of overly committing itself to a pre-determined policy course at a time when economic surprises are all too likely to occur.
Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund’s (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.