A Former Fed President on the Central Bank Now

Jeffrey Lacker served as president of the Federal Reserve Bank of Richmond from 2004 to 2017. During that time, as a member of the Federal Open Market Committee (FOMC), he consistently voted for higher interest rates to help keep inflation in check. Today, he's a member of the Shadow Open Market Committee, an independent group of economists that provides external perspectives on the policy choices of the Fed and other leading central banks. He's also a senior affiliated scholar at the Mercatus Center at George Mason University.

We sat down with Jeffrey to discuss all things Fed—and with Collin Martin, head of fixed income research and strategy at the Schwab Center for Financial Research, to understand the implications for investors.

Jeffrey: The dual mandate is actually a misnomer because Congress enacted language in 1977 directing the Fed to conduct monetary policy to achieve three aims: price stability, maximum employment, and moderate long-term interest rates. Everyone tends to drop the last one because low inflation typically achieves that objective.

Jeffrey: Congress didn't explain what price stability or maximum employment meant. In the 1990s, the Fed settled on 2% as its target for long-term inflation, as measured by the Core Personal Consumption Expenditures (PCE) Price Index.¹ That's its target rate of inflation over the course of a year or two, not every single month.

The Fed has declined to establish a numerical definition for maximum employment, but the two are related. You can get employment to grow faster in the short run, but the consequence is higher inflation later on. It's this kind of keel you have to keep even.

Jeffrey: It's a useful concept; however, the estimates are based on different statistical models, and the confidence bands between them are pretty wide—as much as plus or minus two or three percentage points. You always need to temper the estimate with evidence. Take the example of 2024: The Fed was convinced the federal funds rate was well above neutral, and it cut rates dramatically even though inflation hadn't gotten down to 2% yet. Sure enough, the drop in inflation stalled out at 2.75% to 3%.

Collin: The Fed needs a good estimate of the neutral rate to set a forward-looking policy with any confidence, so its shift to what it calls a more "data-dependent" approach seems to suggest a lack of confidence in the models. When every data point has the potential to change expectations for Fed policy, it may create a lot of uncertainty that can trigger higher volatility in the markets.

Jeffrey: It insulates the central bank from political pressure. With few exceptions, politicians historically have tried to get the Fed to cut rates because they're looking to win the next election. Political leaders have an outsize interest in the strength of economic growth in the next year or two, and they're willing to sacrifice longer-term inflation prospects to achieve that objective. The problem is that it would be really hard for the Fed to manage inflation if it made interest rate decisions in response to political pressure.

At any one meeting, it's easy to question whether the Fed has made the right call. But the Fed needs to be able to make decisions on a meeting-to-meeting basis without being immediately second-guessed. The Fed's independence, though, doesn't mean it shouldn't be held accountable for the results of its actions.

Jeffrey: It was an authority given to Congress in the Constitution when the Federal Reserve System was created. Twice a year, the Fed chair is called to testify at a set of hearings in the House and Senate. It's turned more into political theater in recent years. I think they can do a better job than that, by taking advantage of external experts and conducting a dispassionate scientific evaluation of the Fed's performance rather than just using those hearings to make the Fed a punching bag.

Jeffrey: The Fed communicates more and in different ways than it used to, and those communications send important messages to market participants. On the other hand, I think Fed policymakers often hesitate to reveal too much because they want to maintain discretion and preserve their options. I would like to see them help the public better understand the reasons behind their actions, particularly when they change course.

Collin: Financial market participants hang on every word from the Fed. Hints about changes in policy or topics the Fed is focusing on enable participants to make more informed decisions about where to invest. We get much more information from the Fed now than in the past, which can occasionally prove confusing, but in the long run it helps dampen volatility. Generally speaking, more is more when it comes to the Fed's communications.