clock menu more-arrow no yes mobile

Filed under:

Here's the proof that the Fed doesn't care about faster growth

Federal Reserve Chair Janet Yellin
Federal Reserve Chair Janet Yellin
Mark Wilson/Getty Images

The Federal Reserve just announced something a bit unnerving: they're planning to accept slower growth in the next few months.

Today the Fed wrapped up a meeting of its Federal Open Market Committee, which sets monetary policy. The FOMC announced that it will continue scaling back its "quantitative easing" program, which was designed to inject money into the economy to promote faster growth. At the same time, the board released a new set of predictions for the economy.

But these predictions are much more than just predictions. They're statements of policy.

Earlier this year, FOMC members had predicted that the economy would grow between 2.8 and 3.0 percent this year. Now, the FOMC's members think the economy will grow a more sluggish 2.1 to 2.3 in 2014. Most FOMC members think inflation will be between 1.5 and 1.7 percent in 2014 and that it will stay at or below the Fed's 2 percent target in 2015 and 2016.

To borrow one of Scott Sumner's favorite analogies, suppose you're on a ship that's supposed to be headed for New York. But then a strong wind starts blowing the ship off course. The captain announces that while he'd like to end up in New York, he forecasts that the ship is more likely to wind up in Boston. And no, he's not going to adjust the steering wheel to compensate for the wind.

Of course, if the captain were really committed to going to New York, he'd be turning the steering wheel to the left until the boat was really headed toward New York. A "forecast" by the captain of a ship about where the ship is going isn't really a forecast at all. It's a statement about where the captain has decided to take the ship.

The same principle applies to forecasts of the Federal Open Market Committee. FOMC members aren't just passive bystanders; they collectively control one of the most powerful levers of economic policy. If they wanted to, they could inject more money into the American economy to offset the expected economic slowdown. By forecasting a slowdown, and refusing to announce any policy change to compensate for it, the FOMC is effectively announcing that they're happy with the slower growth they anticipate.

This stance might be understandable if the FOMC believed that surging inflation was imminent. Sometimes you have to accept slower growth to keep inflation in check. But the FOMC members don't believe that. They're forecasting that inflation will stay at or below 2 percent in 2014, 2015, and 2016.

FOMC forecasts are particularly important because businesses rely on them for their own decision-making. And that can make Fed predictions self-fulfilling prophesies. When the Fed lowers its growth forecast and refuses to do anything to offset falling growth rates, that's a signal to businesses that demand for their products is going to be weaker than they expected. Businesses will naturally react to this pessimistic forecast by cutting back on investment, producing exactly the poor economic performance the FOMC predicted.

In contrast, imagine if the FOMC had announced that it was alarmed by the possibility of slower growth, and pledged to pump as much money into the economy as it takes to maintain a 3 percent growth rate. That would be a signal to businesses that demand for its services would be rising in the future. It would cause businesses to invest more today, helping to make the FOMC's bullish prediction come true. Indeed, the announcement that it was determined to achieve higher growth rates might boost growth without the FOMC actually printing very much more money.

So a "forecast" by the Federal Reserve is never just a forecast. It is always, at least implicitly, a statement of Fed policy. When the Fed "predicts" that growth is going to be slower, that's another way of saying that the Fed has chosen not to do any more to boost the economy.

Sign up for the newsletter Today, Explained

Understand the world with a daily explainer plus the most compelling stories of the day.