The Two Things We Need From the Federal Reserve Right Now

As Federal Reserve officials prepare for the start on Wednesday of their two-day policy meeting, they may wish to recall what happened when policymakers in past decades became overconfident in using demand management policy measures to “fine tune” the economy. The lesson learned on more than one occasion is that – apart from threats of high inflation at the one end and recessions or balance sheet implosions at the other end – it is better to maintain a steady policy steer rather than react to every data point. The time has come for the Fed to internalize, albeit belatedly, this lesson.

Policymakers grew increasingly confident at the end of the 20th century that fiscal and monetary policies could be used to deliver a “great moderation.” Some went as far as to suggest that they had “conquered the business cycle.” At the root of this overconfidence in “fine tuning” the economy – something that had also occurred a couple of decades earlier – was a misunderstanding of John Maynard Keynes’s innovative insights into the workings of the demand side of the economy, which was best summarized in his 1936 “The General Theory of Employment, Interest Rates and Money.”