Last week’s decision by the FOMC to cut interest rates was yet another demonstration of a major problem with its current decision-making framework. As has been the case for a few years now, it showed greater commitment to its forward guidance than to its mandate: it lowered the federal funds rate almost entirely because it had signaled it would do so, not because the macroeconomic environment demanded it.
The costliest instance of the Federal Reserve choosing to stick to its forward guidance instead of adjusting to changed circumstances—to remain on its announced policy path for too long—occurred in 2021-2022. As we came out of the pandemic, it refrained from raising rates as inflationary pressures rose rapidly. It was then forced to raise rates in dramatic fashion, by over five percentage points in little over a year. Both the rapid increase in the price level and sudden shift in the interest environment were very disruptive and practically impossible for households to prepare for or hedge against.
The most recent episode is likely to have less harmful consequences but is perhaps even more illustrative of the problem. Over the summer, as inflation came down, the Federal Reserve hesitated to loosen policy for months, treating its eventual 50 basis points cut in September as a regime shift—the end of the hiking cycle and the beginning of a smooth loosening cycle. At the time, it expected core PCE to end the year at 2.6% and unemployment at 4.4%, while projecting 75-100 basis points worth of cuts by the end of the year. Fast forward to today, and while core PCE is higher and unemployment is lower than expected, the FOMC still decided to cut rates by 100 basis points, the top end of the range. (A similar, if anything even starker picture emerges if you compare expectations of economic performance and policy from a year ago to what we have seen materialize.)
This episode is so illustrative because the stakes are relatively low. We are no longer dealing with a once-in-a-century pandemic and are nowhere near the zero lower bound. There is no reason for the Fed not to simply set rates optimally as it receives new data about the state of the economy. It claims its guidance remains useful, as it allows firms and households to plan more carefully. But minor fluctuations in short-term rates do not matter much for that purpose, and it is fine if the Fed adjusts the pace at which it cuts rates or even reverses course, if the situation demands it.
The real risk is that the Fed will once again stick to a path that is no longer optimal for too long, and then has to go in rapid reverse, triggering precisely the kind of interest rate dynamics firms and households are least well positioned to deal with.
