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Uncertainty at the Fed

BERKELEY – The US Federal Reserve is increasingly at risk of losing credibility – and for good reason. As Narayana Kocherlakota, former President of the Federal Reserve Bank of Minneapolis, recently argued, Fed officials seem be balancing their stated aim of keeping inflation near 2% over the long term with a host of other, inexplicit, considerations.

In public statements, officials have given some hints as to what these other considerations may be. They seem to include the risk of distortion in the financial system, worries that unemployment may fall to unsustainable lows, and concerns that raising interest rates too quickly will disrupt economic recovery. But the fact remains that the Fed’s criteria for changing interest rates are for the most part unstated and unclear, making it difficult to predict how it will act.

“This kind of uncertainty – about which goals will define the Fed’s policies – is not healthy,” says Kocherlakota. “Consumers and businesses can’t make good decisions if they don’t have a strong enough sense of how the central bank will act in any situation.”

Kocherlakota is right to be concerned. If anything, he understates the problem. A lack of clarity about the Fed’s economic objectives is just one factor obscuring understanding of its decision-making.