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Central bankers should acknowledge blind spots in a less certain world, Fed’s Mester says

May 24, 2024
in Business
Central bankers should acknowledge blind spots in a less certain world, Fed’s Mester says
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By Howard Schneider

AMELIA ISLAND, Florida (Reuters) – In nearly 40 years working for and helping lead the Federal Reserve, Cleveland Fed President Loretta Mester was part of a revolution that saw the U.S. central bank offer ever more detailed and plentiful commentary on the economy and monetary policy.

As she heads towards mandatory retirement in June, the Cleveland Fed chief has a parting thought: With the economy in flux following the COVID-19 pandemic and with uncertainty surrounding even basic aspects of how things work, precision may be an enemy.

“Markets certainly want to know exactly … ‘when are you going to cut rates?’ That’s what they focus on,” Mester, 65, said in an interview with Reuters on the sidelines of an Atlanta Fed conference this week. “The public … doesn’t want to hear a whole bunch of complicated stuff. They want to kind of know ‘what do you really think?'”

“We’ve become much more transparent over time,” she said, but “we’re not prescient. We don’t know exactly how things are going to be … If the economy evolves differently than you’re expecting, and materially differently, … your policy should respond to that.”

Given how much is unknown, she said the Fed should build more of that uncertainty into how it talks about policy, focusing less on a baseline or “modal” outlook and more on a handful of the most likely outcomes – or scenarios – that would help the public better focus on how policymakers would react when the economy, as will inevitably happen, does something different than expected.

“If you only communicate the modal view, you’re kind of miscommunicating your actual view about the economy to the public,” Mester said, referring to economic projections made early in the pandemic as an extreme example of how any outlook relies on sets of assumptions that she feels are becoming harder to make.

‘ACTIVE DISCUSSION’

Mester is retiring before a Fed review, expected to start later this year, of how the central bank sets policy, the tools it uses to implement its decisions, and the strategy for communicating it – an area she argues needs particular work.

The Atlanta Fed conference in Amelia Island, Florida, this week was focused on some of the questions the central bank wants to answer about the post-pandemic economy, showing a shared sense among policymakers that the upcoming era, coupled with changing trade relations and volatile geopolitics, could prove challenging for central banks to navigate.

David Zervos, chief market strategist for Jefferies, argued, for example, that the Fed’s use of bond-buying during the crisis might be one thing that blunted the eventual impact of monetary policy when rates started to rise because it imported onto the Fed’s balance sheet losses that would otherwise have been borne by the public and driven down spending.

Others delved into ways the U.S. housing market may be muting the central bank’s impact rather than amplifying it, as had been the case in the past, and warned how the broad economic backstops the Fed rolled out during the pandemic might reset the baseline for what it would be called on to do during the next shock.

“It’s an active discussion … as to how we should think about the longer term,” Atlanta Fed President Raphael Bostic said in an interview with journalists on the sidelines of the Amelia Island conference. “We know there have been changes that have come about because of the pandemic, in how labor markets work, in terms of supply chain diversification, and all those things that could change the baseline level of energy in the economy.”

How that plays out over the long term is one thing for analysts to try to understand.

But monetary policy is responsible for stabilizing prices and employment in the short to medium term, an exercise that traditionally focuses on managing demand since that is the aspect of the economy most immediately influenced by interest rates – the cost of borrowing money.

However, it also depends on how the economy is expected to evolve over time, and that calculation becomes complicated if things like productivity, the neutral rate of interest, or the likelihood and impact of supply shocks aren’t either relatively stable or at least changing in familiar and somewhat predictable ways.

BOOSTING CREDIBILITY

The pandemic, Mester noted, essentially put central bankers in the role of epidemiologists and virologists – far from their expertise – since any plausible outlook for the economy depended on assumptions about infections, viral variants, and vaccines.

Similarly, she said, if policymakers can no longer assume that supply shocks quickly fade, for example, or they find the economy responding differently than before to a given level of interest rates, economic modeling and projection lose their footing.

“That increases the level of uncertainty so you have to become much more nimble. How do you set yourself up so that you’re well positioned no matter how things go?” Mester said, noting how the initial assumption that rising inflation in 2021 would prove “transitory” delayed interest rate hikes that she feels could have started earlier and proceeded with less risk and drama.

Better communication about how much the Fed doesn’t know, she said, could help avoid that sort of mistake in the future by discussing, be it in each policy statement or in less frequent documents like the biannual monetary policy report to Congress, the most likely economic narratives and the “reaction function” Fed officials would use in response to them.

Getting the Fed’s disparate group of up to seven governors and 12 reserve bank presidents on the same page about that approach may be a challenge, Mester acknowledged. But in her view it would boost the central bank’s credibility to be blunt about the spread of possible outcomes rather than allow more precise public expectations to develop and then be proven wrong.

© Reuters. FILE PHOTO: Loretta J. Mester, president and CEO of the Federal Reserve Bank of Cleveland, speaks at a conference at the Columbia University in New York, U.S., February 29, 2024. REUTERS/Lananh Nguyen/File Photo

“Let’s just pick three salient scenarios. There’s going to be one that probably has a little more weight on it … This is what we think is going to happen. However, we have these alternative risks.

“That isn’t a trivial thing to do,” she said, but “that can only enhance your credibility.”

>>> Read full article>>>
Copyright for syndicated content belongs to the linked Source : Investing.com – https://www.investing.com/news/economy-news/central-bankers-should-acknowledge-blind-spots-in-a-less-certain-world-feds-mester-says-3456035

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