The Fed's Best Policy: Wait and See

An appropriately placid scene.

Photographer: Mark Wilson/Getty Images

Getting monetary policy back to normal after the crash was always going to be difficult, but this is probably more than the Federal Reserve bargained for. Since the start of the year, global equity markets have tanked and investors' mood has soured. What, if anything, should the Fed do?

On interest rates, nothing -- which is what investors expect from Wednesday's policy announcement. On so-called forward guidance, the Fed's message should be, "There's no reason to panic. We will wait and see what happens."

QuickTake Forward Guidance

The current turbulence in financial markets has been driven mainly by the slump in the price of oil and other commodities, as well as by fears of an economic slowdown in China. It hasn't derailed the U.S. economic recovery. Conceivably, this could happen: If equity prices keep falling and a vicious circle of mounting pessimism and falling demand takes hold, the recovery might be in jeopardy. But for now it seems unlikely.

The gloom over China is overdone. By any other country's standards, its economy is still growing strongly. Though the fall in oil prices has been disturbingly abrupt, it's not without benefits: Cheaper oil raises real incomes and supports demand in oil-importing countries. And the U.S. economy continues to strengthen.

Until the situation is clearer, the Fed should be neither tightening nor loosening monetary policy. Any rough-and-ready schedule of interest-rate increases that the Fed might have had for 2016 -- a dubious idea in the first place -- can now be set aside.

Keeping a close eye on economic data as opposed to market fluctuations, the Fed should move short-term interest rates another notch closer to normal only when it can be confident that the U.S.'s recent economic momentum is genuine. The steep fall in equity prices has delayed that moment -- with luck only briefly, but beyond this month's meeting anyway.

The bigger concern of investors is what happens if the recovery does slacken and fail. Explaining the Fed's decision to begin raising interest rates in December, Chair Janet Yellen mentioned the value of having a "buffer" for future easing, should this be necessary. Now it should be clear what she meant: With short-term rates still close to zero, that buffer barely exists and is sorely missed. A serious setback would require the Fed to think about renewing its bond-buying program, which carries financial risks of its own.

All of which just underlines three inescapable facts: First, the legacy of the recession that supposedly ended in 2009 still clouds the world's economic prospects. Second, persistently low inflation and close-to-zero interest rates make monetary policy fiendishly difficult. Third, a semi-functioning government, capable of sharing the macroeconomic-policy burden, would be a very nice thing to have.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.