Wednesday, August 02, 2006

Does the Fed Need to Look Ahead?

According to conventional wisdom, monetary policymakers need to be forward-looking. Because changes in monetary policy affect the economy with a lag of six to twelve months, the argument goes, central bankers need to look ahead to future economic conditions when setting interest rates and the money supply. This was the point of view advanced recently in Political Calculations:
Mankiw's method has one main drawback - it is backward-looking since it relies on statistics generated by federal government agencies covering the time period from when the data was last reported.
"Mankiw's method" is a version of a Taylor rule that I discussed in a previous post:

Federal funds rate = 8.5 + 1.4 (Core inflation - Unemployment),

where "core inflation" is the CPI inflation rate over the previous 12 months excluding food and energy, and "unemployment" is the seasonally-adjusted unemployment rate.

I have at times made similar arguments myself about the importance of forward-looking monetary policy. But is this conventional wisdom right? Is it possible that if financial markets are forward-looking, then central bankers don't need to be?

Suppose that we get some news that inflation will be picking up over the next few quarters. Under a backward-looking rule such as the one above, the Fed would not raise the Federal funds rate until the higher inflation is realized. Such a delay might seem undesirable. But because long-term interest rates and other asset prices are looking ahead to future Fed actions, they will react immediately. These financial-market reactions will automatically start to put downward pressure on aggregate demand, offsetting some of the inflationary pressure, even before the Fed acts.

Here is a conjecture: To keep inflation contained, it is important that the Fed respond vigorously to inflation, and that financial markets are convinced the Fed will respond vigorously, but it is less important that the Fed respond promptly.

Of course, in practice, if the Fed does not act promptly, financial markets might start to doubt the Fed's commitment to act vigorously (especially when there is a new Fed chair). But once inflation-fighting credibility is established, it might not be very costly for a central bank to follow backward-looking monetary policy rules.