The Fed Needs to Modernize Its Tactics

By Patrick Horan

The Federal Open Market Committee (FOMC), the Federal Reserve’s monetary policy decision-making body, is set to begin cutting its interest rate target tomorrow. As recent as last week, the FOMC seemed set to cut the target by only 25 basis points – or a quarter of a percentage point. However, many economists and other observers are expecting a larger 50-basis-point cut. A larger cut would be welcomed by a camp of Fed watchers who have argued that a big cut is needed to stop the economy from falling into recession. Other economists, however, have argued that the economy is still strong and that the Fed should not be in such a rush to loosen monetary policy.

With inflation trending downward close to 2% and job growth slowing, there is a strong case that the Fed should begin cutting its interest rate target. However, cutting too rapidly and not cutting sufficiently both come with risks. Unfortunately, the Fed’s approach to setting monetary policy is outdated, not moving fast enough to deal with rapidly changing economic circumstances. This makes correcting errors difficult. To ensure better policy, the Fed needs to modernize and be nimbler.

Since 1981, the FOMC has met roughly every six weeks to set monetary policy. The FOMC can adjust its interest rate target by any degree its members want, but it typically does so in increments or multiples of 25 basis points because large, sudden swings in interest rates might be destabilizing.

Although FOMC meetings allow members to discuss the outlook of the economy and where it may be headed, economic conditions can change rapidly over the course of six weeks. The FOMC can also have unscheduled meetings or conference calls to respond to major crises—as it did during the financial crisis in 2008 and early in the COVID pandemic in 2020—but monetary policy can still be unwieldy, as new macroeconomic data can emerge literally every day.

Economist Scott Sumner has argued that with modern technology, there is no reason why the FOMC could not vote on possible changes to the interest rate target much more frequently. For example, FOMC members could email their preferred targets every business day, and the median vote would be the new target for that day. Members could also vote to the nearest basis point. Suppose a new unemployment report shows that unemployment ticked up, but only very slightly. Rather than wait for the next FOMC meeting, a member could vote for a small cut—say, 5 or 8 basis points—the very next day to add liquidity to the economy.

This updated regime would have several advantages. First, it would obviously make monetary policy much more flexible in responding to economic developments. Second, it would make monetary policy behave more like financial markets. Right now, the FOMC tends to move its target rate slowly and is hesitant to move the rate in a direction members did not expect. For example, Atlanta Fed president Raphael Bostic recently urged caution in cutting the target rate too much: “I don’t want to be in a situation where we cut, and then we have to raise rates again. That would be a really bad outcome.”

However, asset prices go up and down all the time in response to new information. Stock prices may go down in response to news about bad weather disrupting crops, but they may go back up a few days later after learning the weather wasn’t as bad as initially anticipated. Similarly, if an increase of 5 basis points on a Monday seemed to be excessive by Thursday afternoon, the FOMC could reduce the target rate by 5 points on Friday.

Third, nothing would force members to vote for a change each day. On some days or weeks, the target may not change if that’s what members wish. However, they could easily vote for a change when necessary, and this would be less likely to panic the public than an emergency meeting. In fact, by voting every day, the FOMC could likely reduce the need to resort to big swings because they would be reacting more efficiently to new developments.

Finally, there is no reason the FOMC could not continue its practice of meeting every six weeks. These meetings would still be important opportunities for members to share their thoughts with each other and for the Fed chair to answer questions from the press.

Right now, the economy is in a good spot. Inflation seems to have settled close to 2%, and unemployment is low by historical standards. However, unemployment has ticked up recently, and recessions frequently start with a gradual rise in unemployment, which then jumps up steeply. Regardless of which way the economy goes next, a modernized approach to interest rate setting would help the FOMC better achieve its goals and better adjust to the macroeconomic needs of the moment.