A Fed Held Hostage by Data Is Asking for Trouble

It’s right for economic data to influence the Federal Reserve’s policy approach. Yet, there is an important distinction between being informed by the numbers and being held hostage by them — particularly for an institution whose tools operate on the economy with a lag. Indeed, the Fed’s often-repeated mantra of “data dependency” risks causing another mistake.

High-frequency inputs on economic activity should inform and influence policymaking, not dominate it. In today’s economy, an excessive focus on the numbers tips the balance of risks toward keeping interest rates too restrictive for too long, unduly increasing the probability of output loss, higher unemployment and financial instability.

The Fed’s current phase of undue data dependency originated with its analytical misreading of inflation as “transitory” back in 2021. By “looking through” multiple indicators of rising price pressures, officials fell behind in their inflation battle and were forced to aggressively raise interest rates. Repeated forecasting errors and poor communication added to the central bank’s woes.

Careful not to make another analytical mistake, policymakers pivoted from “looking through” data to making it their central focus — as is obvious from the number of times it comes up in officials’ remarks. Indeed, this dependency has become deterministic in the Fed’s decision making and communications, and has contributed to uneven signaling, reactive measures, sudden pivots and unnecessary market volatility.

One way to think about this problem is to use the analogy of driving a car by looking in the rear-view mirror rather than through the windshield. This type of driving works for straight roads. It is problematic in other situations. Similarly, the threat of policy mistakes is particularly high during economic uncertainties and rapid changes.