The Fed Follows Misguided ‘Forward Guidance’

The central bank could bind itself to its own forecasts if it were good at predicting the future, but it isn’t.

By Benn Steil and Benjamin Della Rocca. Mr. Steil is director of international economics at the Council on Foreign Relations, where Mr. Della Rocca is an analyst. Excerpts: 

"Against a backdrop of economic gloom, the Fed’s “forward guidance”—that it would keep policy highly accommodative for three years or more—seemed to make sense. Gross domestic product plunged by 9% in the second quarter of 2020, and the Fed was anxious to assure markets it would keep its foot on the gas. After all, the more the markets believed what the Fed said, or so the Fed reasoned, the less it would actually need to do—in terms of buying bonds.

There is, however, a fundamental problem with this strategy. As we have explained on these pages, the Fed isn’t good at predicting economic data—and has been particularly poor at it since March 2020.

Take predictions for economic growth. In June 2020, the Fed expected real GDP for the year to shrink 6.5% from its 2019 level. Yet despite the dismal second quarter, growth rebounded sharply in the latter half of the year and outpaced Fed projections. Real GDP ended the year down only 3.4%.

On inflation, the central bank has performed no better. From February to March 2021, core PCE inflation (the Fed’s preferred measure) rose from 1.5% to 2%—twice as high as the FOMC’s projection in June 2020. And so the Fed revised its forecast for 2021 inflation up to 2.2%. By June, inflation had surged to 3.6%, and the Fed again revised its forecast—up to 3.4%.

Yet even as inflation climbed, and the Fed’s expectations for inflation with it, the Fed’s policy stance did not budge. It continued to anticipate zero rates until 2023.

The Fed’s persistent dovishness breaks with precedent. Research shows that Fed expectations for inflation nine months ahead have, historically, correlated closely with its nine-month forecasts for its own policy rate. Precedent therefore suggests that the Fed should, during the pandemic, have been raising its rate guidance in tandem with its inflation forecasts. It also implies that, had the Fed accurately predicted 2021 inflation in 2020, it would have tightened monetary policy significantly. Specifically, it implies that if FOMC members had foreseen today’s inflation at their December 2020 meeting, its policy rate would now be at 1.9% instead of zero."