Ezrati's Economic Outlook: The Fed Plays With Fire

The crux of the problem lies in the very real possibility that the Fed will find it impossible to stick to its stated interest rate expectations. Though the Fed directly controls short-term rates, it sets them to achieve some anticipated economic and financial effect. Since things seldom work precisely to plan, the Fed frequently has to adjust its rate policy as conditions deviate from expectations. Sometimes, unanticipated economic shocks force the Fed to reappraise its policy. Policy makers failed, for instance, to anticipate either the 2008-09 financial crisis or Europe’s sovereign debt problems. In less dramatic settings, such midcourse changes in rate policy simply acknowledge that the economy or inflation, for instance, have responded faster or slower than expected. A sluggish economic response to monetary easing, for instance, would force the Fed to keep rates lower for longer than it had planned. Stubborn inflation might force policy makers to keep interest rates higher for longer than they had planned. 

When the Fed kept its rate expectations under wraps and people could only guess about rate directions, reactions to policy adjustments had built-in moderators. Some investors and businesses who expected a moderate Fed might have to shift their plans radically in one direction on the news of a midcourse correction. Others, who might have expected a more aggressive Fed, would respond in the opposite way. But with full disclosure from the Fed, there would be less of this bracketing of possibilities. Investors and business people might very well proceed as if the Fed’s rate projections were immutable, instead of contingent on unfolding conditions, and plan as if the future really were definite. Then, when the inevitable midcourse policy corrections occur, all would react in the same way, leading to much more severe economic and financial disruptions than would otherwise have occurred.