Remarks

A Better Way for the Federal Reserve to Steer the Economy

Swedish economist Lars Svensson says the ‘Taylor rule’ is too rigid. The Fed, he says, should use all the information and judgment it can muster.

Jerome Powell, President Trump’s pick to chair the Federal Reserve, will probably spend some of Thanksgiving weekend prepping for his Senate confirmation hearing on Nov. 28. One paper he ought to study, if he hasn’t already, is a Swedish economist’s take on a better way for the world’s most powerful central bank to steer the world’s biggest economy.

Lars Svensson of the Stockholm School of Economics sympathizes with the idea that the Fed should have a systematic method of setting interest rates, but he argues—along with many other economists—that it’s also important for the Fed to use judgment and take advantage of all the information that’s available. He says it would be a mistake to go by the Taylor rule, which takes into account just a handful of considerations, in particular current unemployment and inflation, and isn’t forward-looking. The Taylor rule is named after John Taylor, the Stanford University and Hoover Institution economist who was one of the other finalists for the top job at the Fed.

In October, at a conference sponsored by the Federal Reserve Bank of Boston, Svensson presented a paper advocating what he calls “forecast targeting.” The idea is simple, if not easy to execute. The Fed should agree on a future path for the federal funds rate so that its forecasts for inflation and unemployment “look good.” Looking good means that inflation is at or near the Fed’s objective of 2 percent, and there’s full employment.

According to Svensson, if the Fed gets it wrong on its first try—that is, if its interest-rate path is predicted to leave inflation and unemployment at undesirable levels--it should try again. It should map out out other interest-rate trajectories until it comes up with one in which forecasted inflation and unemployment are where the Fed wants them to be. Then it should publish that forecast for the world to see and tweak it as new information comes in.

In Svensson’s vision, the Fed doesn’t go by where inflation and unemployment are today, as in the Taylor rule. It goes by where the Fed ultimately wants them to end up. It’s like Wayne Gretzky skating to where the puck is going, to use a metaphor a Swede would likely appreciate. 

Here’s Svensson: “In contrast to simple policy rules that rely on very partial information in a rigid way, such as Taylor-type rules, forecast targeting allows all relevant information to be taken into account and has the flexibility and robustness to adapt to new circumstances.”

The European Central Bank and the Bank of England already release staff or consensus forecasts for key variables. Even the Fed does something like forecast targeting, Svensson acknowledges. “Forward guidance,” in which the Fed lays out where it sees interest rates going, is a close cousin of forecast targeting. At a debate on communication in Frankfurt on Nov. 14, top central bankers mostly agreed that forward guidance is a valuable tool.

But it’s not quite what Svensson has in mind. There is no unified economic forecast by the Fed’s decision-makers, who are the members of the Board of Governors and a rotating set of the regional Fed bank presidents. The closest the Fed comes is a Summary of Economic Projections, issued most recently on Sept. 20. That has a few problems. It gives equal weight to voting and non-voting members of the FOMC. More important, it includes only the median projections for various indicators. There is no consensus view of how a given trajectory for the federal funds rate will affect the economy. It’s “more of a snapshot of the views of the FOMC and not a conscious choice by the FOMC,” Svensson writes.

Last year, the Brookings Institution’s Hutchins Center on Fiscal and Monetary Policy surveyed economists about the Fed’s Summary of Economic Projections. Only a third said the famous “dot plot,” which conveys FOMC members’ forecasts for interest rates, was useful or extremely useful. David Wessel, the center’s director, and Peter Olson, a research analyst there, solicited nine suggestions for how to improve the projections, ranging from doing away with the dot plot altogether, to identifying which committee member was behind each dot (e.g., Joe Schmo, 2.125 percent, 2018). 

The economists’ first suggestion for improvement was very like what Svensson advocates. Former Federal Reserve Chair Ben Bernanke, a distinguished fellow in residence at the Hutchins Center, told Wessel and Olson that the FOMC tried to create a consensus forecast in 2012, but “given the large size of the committee and the disparate views represented,” it was “unable to agree on a procedure for developing such a forecast in a timely way.” Still, Bernanke told them, he “thinks there’s potential there, mentioning it as a possible way forward if it can be done.”

    Peter Coy
    Bloomberg Businessweek Columnist
    Peter Coy is the economics editor for Bloomberg Businessweek and covers a wide range of economic issues. He also holds the position of senior writer. Coy joined the magazine in December 1989 as telecommunications editor, then became technology editor in October 1992 and held that position until joining the economics staff. He came to BusinessWeek from the Associated Press in New York, where he had served as a business news writer since 1985.
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