Tony Fratto: To Err is Inflation


Officials here in Istanbul for the annual meetings of the International Monetary Fund and World Bank are echoing calls by G20 leaders since November on the need for coordinated economic policy strategies. And nowhere are coordinated strategies more necessary - and more likely to miss the mark - than with monetary policy.

Why is there such blind faith that central banks will effectively coordinate monetary policy and avoid disruptive mistakes? Maybe it's wishful thinking. Investors seem to be willfully ignoring the limited predictive powers of policy makers, and their often divergent views even while observing the same data.

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While central bankers coordinated well during the financial crisis, they're unlikely to repeat that performance in a post-crisis environment. Central bank action during the crisis was challenging, but then, nothing focuses policy making more than staring into the abyss of a frightening financial meltdown.

Going forward, there are four important factors central banks need to focus on in setting policy rates and exiting extraordinary programs put in place during the crisis:

    1. Timing: When to start taking action?
    2. Sequence: In what order to introduce policies?
    3. Magnitude: How big a move?
    4. Coordination: Act alone, or all in?

During the crisis, when all the data were painfully clear, these questions were relatively easy, respectively: (1) Now; (2) All at once; (3) Huge; and, (4) All in together. Basically, print money, throw everything you've got at the problem, and do it fast.

Looking ahead, achieving fine-tuned policies while considering all of these factors will be tough and very likely to result in some mistakes -- unintended, and despite best efforts -- but mistakes, nonetheless.

For evidence of how difficult these questions are, consider where we were in the summer of 2008. As the U.S. Fed was set on accommodative policy in the face of an apparent recession, the European Central Bank actually raised rates as late as July of that year. This wasn't a simple mistake regarding the relative rate of economic decline -- it was a gross misreading of the overall direction of the economy and the potential effect of a U.S. slowdown on the Eurozone.

Looking at the same global economy, at the same time, and with the same data sets, the two banks arrived at very different conclusions.

Even if central bankers could agree on what the data indicate, economic data is frustratingly, but stubbornly, imperfect. I frequently remind people that we twice revise an original estimate of GDP -- and that's for previous quarter! Trying to pinpoint monetary policy for a large economy six, twelve or eighteen months into the future involves a lot of guesswork.

Getting the policy rate right in a so-called "normal" economic environment is difficult enough. But we're not in what anyone would call "normal". Getting it right while major economies also are considering additional factors -- like the unwinding of fiscal stimulus and crisis-borne special capital and liquidity programs is exponentially more complex.

It's anyone's guess which mistakes are most likely to occur. Fed-watchers here believe the central bank will "err on the side of caution" by leaving rates too low for too long in order to avoid choking off a nascent recovery. If that's the case, then the most likely error will be inflationary.

Efforts at coordination are necessary and should continue. In an interconnected global economy we want economic officials working toward better coordination and better information. But given the challenges facing official policy makers, investors would be wise to expect mistakes.

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Tony Fratto is a CNBC on-air contributor and most recently served as Deputy Assistant to the President and Deputy Press Secretary for the Bush Administration.