Relying too much on data is too risky! Controversy over the Fed's decision-making approach

In the past few months, Federal Reserve Chairman Powell has clearly stated that interest rate decisions will be made gradually based on the data received.

While the Fed publishes a summary of quarterly economic forecasts for each policymaker, Powell described these as only brief explanations of their views at the time.

"What we actually do will depend on the development of the economy," he said at the last press conference on September 18.

This sounds logical, but in the field of monetary policy, this is quite unusual.

Central banks around the world always pay attention to the latest information about the economy, and during periods of short-term deep uncertainty, they let this information guide them. However, Powell's long-standing practice of this approach has begun to frustrate some investors and economists. The latter believe that it is time for Powell to show more confidence in the economic outlook for the next year or so. This would help the public better understand the direction of the Fed's policy.

"Their reliance on data is causing greater volatility," said Drew Matus, a strategist at MetLife Investment Management.

Matus said that the quality of economic data has deteriorated, with most of it being outdated. In addition, data revisions could overturn previous assumptions about the health and direction of the economy. "This is really not a good way to implement policy," he added.

As inflation stabilizes, Powell's critics hope that he will tell a coherent, forward-looking story and then discuss the risks and major issues surrounding this outlook.

Economic Trends are Hard to Predict

The post-COVID economy is like a wild beast. Every time economists try to make predictions, it exceeds expectations, often running in directions analysts did not anticipate.

In 2021, Federal Reserve officials and senior staff believed that the surge in inflation would be "transitory," but it did not drop below 3% until November 2023. After the banking turmoil at the beginning of 2023, calls for an economic recession were rampant, yet the economy grew by nearly 3% that year.

"I sympathize with Powell," said John Roberts, an advisor at Evercore ISI, who has worked on the Fed board for decades, building and refining the U.S. economic structural models used for forecasting. "Shouldn't we think that the Fed's policy is still flexible?"

Nevertheless, decades of research have shown that the effectiveness of monetary policy depends not only on the level of interest rates set but also on market participants' and the public's expectations of interest rate trends for the next year or so, with forecasting being crucial to understanding this. In contrast, relying on a few data points will constrain the Fed to a six-week data cycle.

"Every monetary economist knows that monetary policy runs through the entire term structure, not just the current federal funds rate setting," said Andrew Levin, professor at Dartmouth College and former Fed economist. Therefore, "the Fed needs to clearly explain how it will adjust the path of the federal funds rate if its baseline forecasts prove to be wrong

Data Dependency Leads to Volatility

Recent labor market reports have provided the Federal Reserve with a lesson in the dangers of strict reliance on data. The soft job data in July and August led the Fed, under Powell's leadership, to start a loosening cycle with a significant 50 basis point rate cut.

Then in September, job growth rebounded, with revisions to the July and August readings. Traders pulled back their bets on another large rate cut. Some economists questioned whether the Fed was acting too hastily, causing panic.

Part of the problem that led to the rapid market turnaround is that the Fed does not have a consensus forecast, but rather releases 19 separate forecasts each quarter. Over time, policymakers either embrace the Summary of Economic Projections (SEP) or keep their distance from it, depending on how useful it is to them.

"It's better to have a forecast than not to have one, because it makes the discussion disciplined," said Adam Posen, President of the Peterson Institute for International Economics and former member of the Bank of England's Monetary Policy Committee. "Without a forecast, the discussion is just about everyone's feelings about what will happen next."

The Fed Chair indeed values the committee's views on the economic outlook. Before each policy meeting, he speaks with every FOMC member. Meeting records show that officials' narratives during the meetings are usually very detailed and forward-looking, a practice that Powell continues as Chair. However, these transcripts are not made public until five years later.

In his public remarks following the September meeting, Powell talked a lot about the current situation and described how the Fed would address certain risks. But he did not delve into the medium-term outlook.

Gregory Daco, Chief Economist at EY, stated that Powell's style is more "open to options" than skeptical of forecasts, which is somewhat unusual.

Daco said he is "very candid" about the economic developments. Nevertheless, "a forward-looking perspective would be useful."

Scholars like Posen and former Fed Chair Ben Bernanke, who study inflation targets, believe forecasts are crucial as they help the public and financial markets understand why the central bank is responding to new data in a certain way.

Bernanke, now a Distinguished Senior Fellow at the Brookings Institution, wrote in a commentary on the Bank of England's forecasting methods this year, "Central banks' regular publication of economic forecasts serves multiple communication functions."

He said it "provides a broad basis for public understanding of policy decisions" and "helps align private economic decisions and the overall financial conditions more broadly with the central bank's views, thereby making policy more effective in steering the economy in the expected direction." Claudia Sahm, Chief Economist of New Century Advisors, stated that a reliable and systematic narrative about economic expectations also helps policymakers discuss the risks facing the economic outlook