Former Chairman of the USA National Economic Council Jason Furman recently stated that the Federal Reserve's decision to cut interest rates in December is perplexing but thought-provoking.

At the end of 2023, the median expectation of members of the Federal Open Market Committee (FOMC) is that the economic growth rate for 2024 will be 1.4%, the core inflation rate will be 2.4%, and the federal funds rate will be cut three times. However, the actual economic growth rate is about 2.5%, and the core inflation rate is 2.8%. Given that the economy is much stronger than expected and inflation is also more persistent, the Federal Reserve should have reduced the magnitude of rate cuts, but instead, its cuts exceeded expectations.

The Federal Reserve's latest forecast currently expects further interest rate cuts in 2025, despite its inflation outlook being worse than last year.

Furman pointed out that the traditional argument against rules-based monetary policy is that it requires Federal Reserve officials to preset too many contingencies in advance. Policymakers must examine dozens of Indicators, communicate with businesses and market participants, and consider broader developments in the economy and globally. This is true regardless of the framework the Federal Reserve adopts, and no rule would suggest that it was wise for the Federal Reserve to lower interest rates to zero in March 2020.

Furman believes that the Federal Reserve's judgment is also better than most critics. After committing a serious error by failing to raise interest rates in time, leading to inflation above 5%, the Federal Reserve has addressed the issue more aggressively than its hawkish critics might have thought possible. In 2023, even as dovish figures warned of the risks of a delayed recession and a banking crisis, urging to stop rate hikes, the Federal Reserve insisted on continuing to raise rates.

The current economic situation in the USA is not flawless, and a soft landing is still difficult to achieve, but the situation has improved significantly.

However, Furman argues that when it comes to the Federal Reserve replacing rules with its own judgment, rules appear to be better than judgment. If the Federal Reserve had followed any version of the Taylor rule, it would not have needed to make so many large rate hikes in 2022 and 2023; the rule should have prompted rate increases starting in 2021 based on inflation and unemployment rates. Preliminary progress on inflation in the second half of 2023 should have led to an earlier adjustment of rates, without the need for significant cuts in September 2024 to catch up.

Furman suggests that as the New Year approaches, the Federal Reserve might consider shifting to a more rules-driven MMF policy, which will include three urgent priorities.

First, the Federal Reserve should be clearer and more consistent regarding its medium-term inflation targets. The long-term overall inflation target remains meaningful, as it is a public concern, but the Federal Reserve should more clearly state what it is focused on in the short term to distinguish signals from noise. He said, "If I had to choose an indicator, it would be the marketized core PCE price year-on-year. Different potential inflation measures do not vary much in predictive ability, so the most important thing is for the Federal Reserve to choose a measure and stick with it."

Secondly, the Federal Reserve should choose a rule, or set of rules, and announce its stipulations at each FOMC meeting. If the path chosen by the committee differs from the rules or suggested rules, it must explain what kind of judgment led to this situation. Furman stated that he prefers a version of the Taylor rule based on past interest rates and current economic conditions, giving more weight to the unemployment rate. This would make policy changes smoother over time. Similarly, it is crucial to choose a rule and stick to it. This approach currently suggests a federal funds rate of around 5%, above the current 4.25% to 4.5%.

Finally, Furman noted that if the Federal Reserve deviates from its rules over time, it must do so without bias. He said it is always easy to find reasons to explain why interest rates should be lower rather than higher. While this may be correct at any given time, cumulatively, it can lead to an inflation bias in monetary policy. Therefore, the Federal Reserve must adopt a practice that allows for deviations from its rules equally in both directions.

Furman concluded that placing more emphasis on rules could address several issues; it would make monetary policy more predictable and understandable, reduce market volatility, and promote better investment decisions. It could also prevent biases that have gradually infiltrated the Federal Reserve's decision-making in recent years. Changes in monetary policy will be easier to explain, and the Federal Reserve's response to incoming data will be more stable, but data changes mean that policy will change accordingly. Clearer rules do not eliminate the need for judgment, but they can help curb bias and enhance confidence in overall policy.

Editor/Jeffy