End the Fed’s Guessing Game

The FOMC decided last week against raising interest rates given its concerns about the global economy and financial conditions. While these concerns are reasonable, the FOMC’s decision highlights a growing problem that has increasingly plagued the Fed since the crisis erupted: its incredibly ad-hoc approach to monetary policy.

Just a few months ago the FOMC was signaling it would almost certainly raise interest rates, but now it has changed its mind. This change would not be so bad if it were predictable, but it was not so. No one expects the Fed to perfectly forecast the economy, but we should expect the Fed to make clear how it would respond to differing states of the economy. This simply has not happened. From the QE programs to forward guidance to lifting interest rates from zero, Fed policy has been made up on the fly. This unpredictable behavior has meant that no one, including Fed officials, knows for sure what will happen from one FOMC meeting to the next.

As a result, markets have become more and more obsessed with every word coming from the mouths of Fed officials. Post-FOMC press conferences like the one last Thursday became must-watch TV for anyone concerned about investments. Ironically, then, the Fed’s attempt to calm markets through these ad-hoc measures has only made them more fragile.

It would be far better for the Fed to focus on a narrow mandate in a rule-like manner that makes conditional forecasts possible. For example, if the Fed were to target a stable growth path for total dollar spending and adjust policy as needed to hit it there would be far less of the Fed’s current guessing game. The FOMC’s decision last week highlights how sorely this change is needed.

[Cross-posted from Alt-M.org]