The Fed's Credibility Dilemma
Federal Reserve officials often use two words to summarize their plans for monetary policy over the next three years or so: "gradual normalization," meaning that interest rates will move slowly and in an upward direction. It's a phrase that could prove problematic if economic developments require a different response.
In public statements and projections, Fed officials have suggested that gradual normalization would entail increasing interest rates by less than a percentage point in each of the next three years. Their aim is to provide markets with confidence-building guidance, but the strategy will work only if the economy proceeds along the trajectory that the officials expect.
Imagine, for example, what will happen if inflationary pressures prove stronger than expected over the next year or so. In principle, the Fed can curb inflation by raising its interest-rate target sufficiently rapidly. In practice, however, it faces a dilemma: It must break either its commitment to move gradually, or to keep inflation close to 2 percent. No matter what it does, it will lose credibility.
Worse, suppose that economic growth turns out to be weaker than the Fed anticipates (an adverse shock that I consider more significant than the inflation scenario). As former Chairman Ben Bernanke has explained, the central bank could respond by taking interest rates negative. Again, though, communication becomes an obstacle: By expressing its strong preference for normalization, the Fed has been telling investors that they can safely ignore the possibility of a reduction in rates (at the end of her March 16 press conference, for example, Chair Janet Yellen stressed that officials are not even discussing the possibility of adding stimulus). So to respond appropriately to an adverse shock, the Fed would have to renege on its implicit commitment.
Ironically, the Fed's perceived commitment not to cut interest rates could actually make it reluctant to raise them. Markets will perceive each new, higher interest-rate target as a floor, further limiting the central bank's room for maneuver. So if Fed officials want to maintain flexibility -- because, say, they’re worried about downside risks -- they might choose not to raise rates in the first place. That way they'll run a smaller risk of being forced to go back on their normalization commitment.
So what, if any, plans should the Fed communicate? For one, officials must recognize that their expectations for the economy, like all forecasts, are likely to prove wrong. As a result, they should be much clearer about their willingness to make large and rapid changes in monetary policy. Instead of talking about gradual normalization, they should stress that they are ready to do “whatever it takes” to keep employment up and inflation near target.
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