The Fed needs a new strategy for 2019

JEROME POWELL, chairman of the Federal Reserve, says “basically everything” keeps him up at night. As well it might. The fiscal stimulus from President Donald Trump’s tax cuts, which in 2018 has shielded America from a global economic slowdown, will soon begin to subside. The president’s trade war is sapping confidence. The S&P 500 index has fallen by almost 10% in a little over two months as growth expectations have ebbed. The difference between yields on short-term and ten-year bonds, which typically turns negative before recessions, has fallen close to zero, spooking investors. To cap it all, the president has been attacking the central bank for raising interest rates, which it has done three times this year to try to ward off inflation.

Mr Powell seems to have wavered under the pressure. In October he hinted that investors should expect many more rate rises before the Fed’s work was complete; in November he suggested that hardly any more are needed. Mr Powell is rooting around for a doctrine because the one he inherited when he took over the job in February, which calls for monetary policy to tighten roughly once a quarter, is becoming obsolete. A rate rise remains likely at the Fed’s upcoming meeting, which concludes on December 19th. But it will probably be the last on a predictable schedule. In 2019 a fresh course will be needed—one that is fit for a new phase in the economic cycle.

The Powell doctrine should be centred on humility. The Fed’s rate-setters have for years justified rate rises with predictions that America’s jobs boom would soon turn inflationary. Yet even with unemployment at just 3.7%, core inflation—the measure that matters most—is slightly below target and falling. Headline inflation is on target, but may soon be dragged down by a falling oil price. Inflation expectations have fallen slightly. As the horizon darkens, rate rises will need weightier justification than an inflation risk that has been perennially exaggerated.

The central bank has a record of dangerous complacency late in economic cycles. Before the past two recessions it raised rates, pointing to low unemployment, despite signs in bond markets of a coming slowdown. Optimists explained away traders’ apparent pessimism using arguments that have started to crop up again today. In reality, markets were ahead of policymakers, as they probably will be the next time trouble strikes. Economists typically fail to predict downturns until they are imminent (see Graphic detail).

The Fed’s poor forecasting record has implications for monetary policy. Rate-setters should rely less on predictive models and more on realised economic and financial data. They should also abandon their insistence that unemployment is already unsustainably low, a claim that is at odds with the evidence and which will lead the central bank to hit the brakes too hard. And the Fed should state that it expects to hold rates steady in 2019 unless circumstances change materially.

Mr Powell may well worry about overreacting to bad news. Growth will surely slow as fiscal stimulus wears off, so softening economic data, in the housing market say, do not justify panic. Mr Powell may also need to signal that he will not kowtow to Mr Trump. (Though the president would struggle to remove the Fed chairman over policy disagreements, it may be possible.) Central banks do not exist to prop up stockmarkets—which can fall for reasons, such as waning euphoria, that are mostly unrelated to the objectives of monetary policy.

The right balance can be found by raising rates now while signalling a change of course for 2019. The American economy can cope with another rate rise. But if the central bank continues to tighten monetary policy at the current pace, it is likely to make a costly mistake before long. To avoid that fate, Mr Powell must develop his own doctrine for the Fed.