The Fed's "Big" Mistake---- Continuing to Use Its Forward Guidance Framework As A Policy Tool
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The Federal Reserve's persistent use of the 'forward guidance' policy tool, which involves offering forecasts of growth, inflation, and policy rates to influence financial market conditions, is a misguided approach. This tool operates under the assumption that the Fed can accurately predict the future, a notion that is inherently flawed given the unpredictable nature of economic conditions.
In 2023, policymakers used its forward guidance policy tool to signal an end to its tightening policy cycle, thinking it had or would, in time, arrest the cyclical inflation cycle. At the end of the year, it went further, as it offered forecasts for 2024 that promised three official rate cuts.
Yet, in hindsight, forward guidance backfired. Promises of no more rate hikes followed by promises of lower official rates triggered a 100-basis drop in long bond interest rates and double-digit increases in equity prices. The dramatic change towards much easier financial conditions has helped produce economic results that the Fed was not expecting in its forward guidance. (Note: Q1 real GDP growth is estimated at 3%, while core consumer prices rose at an annualized rate of 5%, compared to forward guidance growth estimates of 2% and core inflation of 2.4%).
The challenge for policymakers is how to navigate the modification or discontinuation of the forward guidance policy tool. Forecasts from forward guidance are updated only four times a year, with the next update scheduled for the June meeting. While the Fed chair can provide an informal update at any time, official policy announcements are made at regularly scheduled meetings. A sudden deviation from the last forecast could disrupt the financial markets and undermine the Fed's credibility, if it still has any.
Yet, the problem with "forward guidance" goes well beyond the announcement dates. Policymakers offer forecasts on growth, inflation, unemployment, and policy rates for two years and a longer-run equilibrium level for each. And, regardless of whether current economic conditions are too hot or soft or inflation is too low or high, the Fed's forward guidance forecasts say, through the magic of monetary policy, growth, unemployment, and inflation will gravitate to trend.
Like everyone else, the Fed has had difficulty forecasting what the economy will be like in the next year, let alone in two or three years. Yet, unlike other forecasters, policymakers link an official rate path to its forecasts. That linkage makes official policy more predictable. However, it also creates the potential for a significant easings in financial market conditions, similar to what occurred since late 2023, long before policymakers achieved their intended outcomes.
Policymakers spent time "normalizing" official rates, and now they need to "normalize" their policy statement, making it shorter and with fewer promises. Eliminating forward guidance would also be a positive step because even though it implies "it all depends," it still drives market expectations of official rates.
Joseph G. Carson
AuthorMore in Author Profile »Joseph G. Carson, Former Director of Global Economic Research, Alliance Bernstein. Joseph G. Carson joined Alliance Bernstein in 2001. He oversaw the Economic Analysis team for Alliance Bernstein Fixed Income and has primary responsibility for the economic and interest-rate analysis of the US. Previously, Carson was chief economist of the Americas for UBS Warburg, where he was primarily responsible for forecasting the US economy and interest rates. From 1996 to 1999, he was chief US economist at Deutsche Bank. While there, Carson was named to the Institutional Investor All-Star Team for Fixed Income and ranked as one of Best Analysts and Economists by The Global Investor Fixed Income Survey. He began his professional career in 1977 as a staff economist for the chief economist’s office in the US Department of Commerce, where he was designated the department’s representative at the Council on Wage and Price Stability during President Carter’s voluntary wage and price guidelines program. In 1979, Carson joined General Motors as an analyst. He held a variety of roles at GM, including chief forecaster for North America and chief analyst in charge of production recommendations for the Truck Group. From 1981 to 1986, Carson served as vice president and senior economist for the Capital Markets Economics Group at Merrill Lynch. In 1986, he joined Chemical Bank; he later became its chief economist. From 1992 to 1996, Carson served as chief economist at Dean Witter, where he sat on the investment-policy and stock-selection committees. He received his BA and MA from Youngstown State University and did his PhD coursework at George Washington University. Honorary Doctorate Degree, Business Administration Youngstown State University 2016. Location: New York.