As Federal Reserve officials prepare for the start on Wednesday of their two-day policy meeting, they may wish to recall what happened when policymakers in past decades became overconfident in using demand management policy measures to "fine tune” the economy. The lesson learned on more than one occasion is that - apart from threats of high inflation at the one end and recessions or balance sheet implosions at the other end - it is better to maintain a steady policy steer rather than react to every data point. The time has come for the Fed to internalize, albeit belatedly, this lesson.
Policymakers grew increasingly confident at the end of the 20th century that fiscal and monetary policies could be used to deliver a “great moderation.” Some went as far as to suggest that they had “conquered the business cycle.” At the root of this overconfidence in “fine tuning” the economy - something that had also occurred a couple of decades earlier - was a misunderstanding of John Maynard Keynes’s innovative insights into the workings of the demand side of the economy, which was best summarized in his 1936 “The General Theory of Employment, Interest Rates and Money.”
It was a policymaking phenomenon that, once again, had gone too far, oversimplifying Keynes’ critical insights. And it was one that was again blown apart by a series of disruptive events, quite a few of which were caused by a lack of humility.
The alternative for policymaking was to substitute overconfidence in fine tuning based on high frequency data, with a preference for steady and sustainable policy postures. This was accompanied by greater emphasis on the supply side of the economy, particularly the factors impacting productivity, investment and growth. The exception, rightly, was at the more extremes ends of the distribution of potential economic outcomes, and whether this meant countering inflation surges or avoiding recessions and implosions caused by a disorderly deleveraging of private sector balance sheets.
After its 2021 policy mistake of mischaracterising inflation as “transitory,” the Fed seems to have lost sight of this lesson. Its obsession with data dependency has seen it overreact to noisy historical data, lacking the more strategic forward-looking approach needed when using policy tools that operate with “long and variable lags.” The resulting policy flip-flops, be they in actual measures or forward guidance, became quite noticeable in the last 12 months, fueling wild gyrations in market expectations of policy rates and related bond yields that serve as benchmarks for many financial instruments in the US and beyond.
Consider the following. A Fed that saw no need to cut interest rates at the end of July proceeded to do so by an unusually large 50 basis points at its next policy meeting in mid-September, slashing the target federal funds rate to a range of 4.75% to 5% from a range of 5.25% to 5.50%. The intention to “go big” rather than validate the 25 basis points that the market expected at that stage, was communicated unusually via newspaper “leaks” during the so-called blackout period that proceeded the policy meeting. Adding to the confusion, the upsizing of the cut was countered by a subsequent increase in 10-year US Treasury note yields of more than 70 basis points, the process of which led a number of Fed officials to seemingly step back from the decision they had taken.
The market's reaction was but one of many wild moves. Others included the dramatic drop in expectations of another jumbo 50 basis-point cut by the Fed, from 60% to zero in the two-week period to Oct. 4. There has also been a dramatic change in the market’s assessment of the terminal federal funds rate for this cutting cycle. The probability of getting to under 3.25% by June 2025 fell from almost 80% to zero.
Fortunately, the inherent strength of the US economy, often referred to as “economic exceptionalism,” has served as an effective shield against the potentially damaging effects of such policy and market volatility. But this is not a reason to continue on this path, especially given the uncertainties facing the country’s fiscal, trade, regulatory and industrial policy outlook.
Two things are needed from the Fed, and it can start as early as this week.
The first is a steadier hand on the steering wheel. With most agreeing that there is some room to go before reaching a “neutral rate of interest,” the Fed would be well advised to signal and deliver a steady pace of 25 basis-point cuts at its next few meetings. Second, in its assessment of policies and economic outcomes, the Fed should recognize that, after years of dominating the policy centerstage (“the only game in town” phenomenon), it is time for it to make room for other policymakers. Indeed, the outlook for the US economy from here will depend much more on what happens elsewhere in the policy world post-election.
“Having too much of a good thing,” a phrase said to have been first used in the Shakespeare play ‘As You Like It’, echoes the important economic lesson learned in past decades when policymakers became overly confident in their ability to “fine-tune” the demand side of the economy. It is important for the Fed not to lose sight of that lesson.
Credit: Bloomberg
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