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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
It was not supposed to be this way. By now, the Federal Reserve should have been able to declare “mission accomplished”, closing the chapter on a period when US inflation ran higher and longer than it should have. In doing so, it could also have pointed to its success in avoiding the economic “pain” it warned about in August 2022 in tackling rising prices.
Instead, the Fed will have to navigate a summer that will see both elements of its twin objectives — low inflation and maximum employment — threatened. It will continue to fend off attacks from the White House, especially now it has signalled that any potential rate cut this year is unlikely to materialise until September at the earliest. And it is committed this year to rolling out a new monetary policy framework that is likely to remind many people of the major deficiencies in the existing one.
The list of challenges does not stop here. The Fed is operating in an unstable environment where the historical economic relationships that are inputs to its policy formulation are more unstable. The central bank must keep an eye on the dollar — its persistent weakness raises some uncomfortable questions about its long-standing role in the global economy and that of US financial markets as the unquestioned recipient of foreign savings. Then there is the periodic worry about the functioning of the US Treasury market.
In the Fed’s defence, many of the challenges are due to factors beyond its control. Four, in particular, have contributed to what I believe will go down in history as an extraordinary period of volatility.
The first is, of course, the twists and turns in the US approach to tariffs. The weaponisation of this economic policy tool is accompanied by some confusion about the Trump administration’s priorities. Is it adopting an “escalate to de-escalate” strategy where higher tariffs seek to ensure a fairer trading system and are likely to be temporary? Or is it a new world of long-standing tariffs to bolster budgetary revenues and reshore manufacturing activity?
The second factor is uncertainty over the administration’s policies in general, but particularly its approach to public finances. The full implications of the “big, beautiful” budget bill going through Congress are yet to be felt. It is also unclear how the reset of government employment and contracts will evolve. And there is yet to be clear visibility on the size, shape and timing of the White House deregulation plans.
The third factor is the set of unusual data inconsistencies. Soft data, which captures how companies and households feel, has been flashing red for months, warning of lower growth and higher inflation. Hard data, which relates to what they do, has yet to confirm either of these.
The fourth factor is much more positive — the productivity-enhancing potential from innovations, particularly artificial intelligence. Yet, importantly, there is no consensus on the magnitude and timing of such developments.
All this complicates the Fed’s ability to forecast and act at a time when stagflation has risen as a risk. This is also made harder by the erosion of Fed policy credibility — an essential factor for effective forward policy guidance.
Given what is at stake, the central bank has no choice but to spend much of this summer playing defence. Yet it should not be limited to this. It also needs to go on the offensive by rolling out a more credible monetary policy framework, including by drawing on the recommendations of a recent G30 working group that, for full disclosure, I was part of. They include improving communication by measures such as creating and publicly releasing a formal structure for the use of forward guidance on policy; publishing staff forecasts; giving explicit guidance on the trade-offs between employment and inflation; and developing a transparent framework to assess quantitative easing and tightening programmes.
The Fed should also be more open to using a range of scenario analyses, as former New York Fed president Bill Dudley and others have argued. And it should upgrade its granular understanding of the impact of economic forces on households and companies.
Finally, there should be one further strategic consideration for the Fed this year: reviewing its 2 per cent inflation target. Surely, this requires consideration given how much is changing structurally in the economy. Yet it has already been explicitly and repeatedly ruled out by the Fed. In current circumstances, that might seem an obvious defensive move but it could well prove a missed opportunity.
