Why the Fed needs to keep an open mind

After the most recent US inflation report again exceeded expectations, with prices surging 9.1% in the year to June, investors have been wondering whether the Federal Reserve would accelerate its monetary tightening for a second time — raising its policy rate not by the previously indicated 75 basis points, but by a full percentage point.
Expectations seem to have settled on the smaller number for now, with more to come later. But it’s a pity discussion still dwells on the path of future rates. This obscures what’s most important. The economic outlook has rarely been as puzzling as it is now, and the Fed needs to be more flexible than usual. Whatever the interest-rate decision, officials should be careful not to box themselves in.
Forward guidance is evidently a hard habit to break. For years, with the policy rate stuck at zero, the central bank had only two ways of easing any further. One was to promise that rates would stay at zero beyond the point at which it might ordinarily raise them — a commitment to “lower for longer.” The other was to adopt a new schedule of bond purchases, or quantitative easing, to press down on long-term rates. In effect, the Fed had to tie its own hands.
This makes its initial reluctance to raise rates when inflation took off last year easier to understand. But now that the policy rate is back above zero, the central bank needs to be more agile. Setting out paths for interest rates and quantitative easing has become counterproductive.
This would be true even if the outlook were well understood, but it isn’t. Although inflation is high and the labor market is tight, output fell in the first quarter. The advance estimate of second-quarter gross domestic product might show another decline. As a rule, you’d call two consecutive quarters of negative growth a recession — and it would be strange to raise interest rates if the economy were shrinking.
Yet who knows? The combination of the pandemic and the supply shocks induced by Russia’s war on Ukraine has scrambled every kind of macroeconomic indicator. The downturn in growth might be an illusion: Even in normal times, the figures can be heavily revised, and other measures are telling a more upbeat story. Pointing the other way, today’s low unemployment could itself be misleading. If the cause is a temporary contraction in the labour force, an extended period of high demand might not cause further overheating. Anyway, some of the recent inflation spike is indeed temporary, and monetary tightening can’t address supply-side disruptions.
Given all this, anything resembling a plan for interest-rate changes through this year and next is absurd. A rise is warranted, to be sure, because the current policy rate of 1.5% to 1.75% is very low in inflation-adjusted terms and would be adding to demand even if inflation were back on target. A rate of 2.25% to 2.5% would be closer to the so-called neutral rate. Without clear evidence that aggregate demand is stalling, anything lower is hard to justify.
But here’s the main thing: After this week, rates might need to go up further or be pushed back down, depending on what happens next. The best the Fed can do is make this clear to financial markets, closely watch the trend of demand, and keep an open mind.

—Bloomberg