The US Fed should inject itself with a good dose of humility

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Yet, what has made this bad luck worse and more consequential for overall economic well-being is that it has interacted with self-created weaknesses. Unlike other Feds, those have extended to analysis, forecasts, communication and policy responses, repeated missteps that were aggravated by a distinct lack of humility and learning. 

The result is a Fed whose political independence and market credibility are as shaky as they have been since the late 1970s and early 1980s. And that is bad news for a central bank that faces difficult policy options. It’s also bad news for the US economy that has lost other anchors and is suffering its own period of instability at the centre of the global economic and financial order.

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The Fed’s latest stroke of bad luck is highlighted by the recent rush of major Wall Street firms to revise US economic forecasts. One after the other has lowered its growth projections, hiked inflation and warned that the balance of risks to the economy remains unfavourable even after these revisions. 

The policy dilemma for the Fed’s pursuit of its dual mandate was made vivid by JPMorgan’s upward revisions in unemployment to 5.3% and inflation all the way up to 4.4%. The main driver of these revisions—the effects of higher tariffs on US trade partners [partly paused for all countries except China for 90 days]—is significantly more challenging than what the Fed faced in the past. It involves more extensive surcharges, can trigger a range of reactions from trade partners and confronts companies with a spaghetti bowl of dynamic supply and demand uncertainties to deal with.

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Also, whereas the required Fed policy response was obvious when the pandemic froze the economy, and unlike the aftermath when the central bank’s initial mis-characterization of inflation left no doubt over what needed to follow, interest rate wise, the Fed’s current policy formulation is fraught with uncertainties and danger. In his March press conference, Powell dismissed weakening soft data and re-introduced the term ‘transitory’ while opining on the inflationary effects of tariffs. Fortunately, he walked back both statements last week, rather than wait for many months as he did in 2021.

Now the Fed needs to judge whether it should respond to prospects of higher unemployment by cutting rates aggressively, or to hotter inflation by staying put or even opening the door to the possibility of a rate hike. For their part, market participants have rushed to price in more than four reductions this year, with some even calling for an emergency cut.

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The reaction of traders and investors should not come as a surprise. It reflects how they have been trained repeatedly by the Fed to expect looser financial conditions the minute there are any signs of unusual market volatility or economic weakness. And, judging from its history, it is probably what this Fed will be tempted to do.

Yet, the expected rise in inflation makes such a policy response far from straightforward. Indeed, it could even be dangerous. Having failed to bring inflation back down to its often-repeated target three years after annual consumer price rises topped 9%, the Fed faces the risk of protracted inflation that would undermine its efforts to counter the potential rise in joblessness. Moreover, lessons from central banking history suggest that when faced with both parts of the dual mandate going against it, the Fed should give priority to putting the inflation genie back in the bottle.

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This is a particularly relevant consideration in the current situation, where the sensitivity of unemployment to interest rates pales in comparison to the uncertainties companies and households feel due to the manner tariff policy has been designed, communicated and implemented. Indeed, to quote the guidance provided on Bloomberg Television last week by Eric Rosengren, former president of the Boston Fed, the issue of rate cuts should be approached “slowly, gradually and reluctantly."

What the Fed needs more than ever at this juncture is a good dose of humility, something that it has lacked in recent years to its and the economy’s detriment.

Such humility would help reduce the risk of another bout of slippages in analysis, forecasts, communication and policy design. It would also help counter the threat of a prolonged and damaging period of stagflation. ©Bloomberg

The author is a Bloomberg Opinion columnist.