MNI INTERVIEW: Fed Likely To Wait And See On Scenarios - Bordo

The Federal Reserve should regularly discuss alternate analyses of the economic outlook that allow for large changes to its baseline forecast, but it is likely that U.S. policymakers will wait to observe the experience of other central banks taking such an approach before deciding whether to follow suit, Rutgers University economist Michael Bordo told MNI.

Former Fed Chair Ben Bernanke’s recommendation last month that the Bank of England expand its use of scenarios to quantify risks to its central forecast cited a 2020 paper by Bordo, Andrew Levin and Mickey Levy, members of the watchdog Shadow Open Market Committee, that urged the Fed to explaining its policy strategy at the height of the pandemic using different scenarios of vaccine success rather than focusing on a single benchmark projection.

"We live in a stochastic world and there are always shocks, things you can’t predict. You can’t just assume what the world is going to be based on the models you follow. Scenario analysis, it seems to me, is a way of cross checking everything else you do," Bordo said in an interview.

"They have to be very humble and to say: we don’t really know, history tells us what could happen, but we want you to know what we’re thinking and that we're doing the best we can to deal with uncertainty."

HISTORY-BASED HYPOTHETICALS

The scenarios sketched out in the 2020 paper were based on relevant historical episodes, including the Spanish flu pandemic of 1918-19, Great Depression of the 1930s and the economic transition at the end of World War II. Bordo suggested the Fed could also compare the current situation of sticky inflation to similar events in the past to create useful alternative scenarios.

It took inflation some five years to dip below 3% after Fed Chair Paul Volcker left office in 1987, but that's not likely to be the case today, Bordo said.

Better communication and more transparency at the central bank have better anchored inflation expectations, making monetary policy more effective. Financial markets are also more efficient and many fewer workers are unionized today, meaning contract wages aren't often linked to inflation, he said.

"You pose a scenario and compare what the scenario says with where you are today and say what’s different about it. From that, you say we should keep this in mind and these are the kinds of policies we want," Bordo said.

Such analyses would be most useful when faced with big shocks like a pandemic or a war, but could still be useful in normal times, he said. The Riksbank is already doing this and if the BoE has success with scenario analysis, the Fed may adopt changes some years from now, he said. (See MNI INTERVIEW: Limits To Comms Benefits From Fed Scenarios)

NO HURRY TO CUT

Bordo said he's optimistic the Fed can bring inflation back to target barring some new shock, but the FOMC should avoid cutting too soon lest inflation bounces back.

"I don’t always agree with them, but my impression today is they’re really not in such bad shape," he said. "Just keeping real interest rates where they are, they’re pretty close to the Taylor rule, and the real interest rate is probably where it should be. Maybe it can come down a little bit."

Last year, the FOMC signaled too many cuts when it should have been more circumspect, he said. "If you do stuff like that and the market believes you, but it turns out the world is different, then you have a credibility problem. I would want them to be awfully cautious about saying what they're going to do when they don’t know what the future is going to be."

But, "getting down from 3% is not as difficult a situation as getting from 10% to where we are," he said. "Scenario analysis can help." (See: MNI INTERVIEW: CPI Keeps Fed On Track For '24 Cuts-Ireland)