The Federal Reserve is stuck in a mode of forecasting and public communication that looks increasingly limited, especially as the economy keeps delivering surprises.
The issue is not the forecasts themselves, though they’ve frequently been wrong. Rather, it’s that the focus on a central projection — such as three interest-rate cuts in 2024 — in an economy still undergoing post-pandemic tremors fails to communicate much about the plausible range of outcomes. The outlook for rates presented just last month now appears outdated amid a fresh wave of inflation.
An alternative method starting to gain steam is called scenario analysis, which involves emphasizing a range of credible risks to the baseline and how a central bank might respond. It’s a tactic that becomes especially useful in times of high economic uncertainty.
“The Fed urgently needs to incorporate scenario analysis into its public communications,” said Dartmouth College professor Andrew Levin, who was a top adviser to former Fed Chair Ben Bernanke. Levin describes it as “stress tests for monetary policy.”
Bernanke himself is currently making a similar case across the Atlantic. He recommended the Bank of England adopt such an approach in a report published this month for the UK central bank. It wouldn’t be the first to do so: Sweden’s Riksbank, for example, already uses scenarios to think about alternative policy paths.
Publishing both central and alternative scenarios means “the public will be able to draw sharper inferences about the reaction function and thus better anticipate future policy actions,” Bernanke wrote in his review of the BOE’s forecasting methods.
A sizzling economy continues to surprise Fed officials. From December to March, they revised up their outlook for growth in 2024 by a substantial 0.7 percentage point and projected three rate cuts this year, according to their median estimate.
Higher-than-expected inflation data quickly rendered that call obsolete, at least in financial markets: Investors have dialed back the number of cuts expected this year, while options markets say the probability of one cut or less is about a coin toss.
The projections represent a compilation of the views of 19 policymakers about the likely trajectory for growth, unemployment, inflation and interest rates. By design and intention, the Fed trains the eyes of investors and analysts on the median estimates. But at times like the present, when the economy is highly unpredictable, the full range of views acquires more importance.
In March, for example, nine of 19 officials wrote down two rate cuts or fewer for 2024, a view that has suddenly become more plausible with the arrival of the latest inflation figures. Fed Chair Jerome Powell’s constant refrain is that what the central bank ultimately decides on rates will depend on the data, though he has leaned into the rate-cut narrative this year.
Without a sense of how officials might revise their path for rates in a “hot economy” scenario, “any shift in these outlooks creates more volatility,” said Ira Jersey, chief US interest-rate strategist at Bloomberg Intelligence. “Understanding how the Fed is handicapping such potential outcomes could provide valuable information,” he said.
Fed staff economists do run scenarios for policymakers. But they are model-driven, don’t reflect an agreed-upon anticipated reaction of the rate-setting committee and are irrelevant for communications purposes since they are made public only with a five-year lag.
… “There is no getting away from the fact that policymakers are laying out a single policy path and they need a modal outlook,” said Ellen Meade, a Duke University professor and former Fed board staff member. Once they have that, “scenarios can be good for discussing with the public about the fact that the modal path is not 100% or set in stone and what the most prominent risks are.”