The Harder Promise: Showing What Policy Would Do
The Federal Reserve's alternative scenarios become harder to communicate when they include a policy response, because the policy rate is both a cause of economic outcomes and a response to them. This chapter focuses on that feedback loop and on the broader shift from descriptive forward guidance toward more conditional policy communication. The practical judgment is to distinguish a shock scenario from a response scenario, understand what a policy rule can and cannot represent, and weigh the flexibility of conditionality against the predictability that households, businesses, and markets want.
A policy response changes the scenario itself
An economic scenario can be constructed with the policy rate held on the same path as in the baseline. That choice isolates the consequences of the shock: what would higher tariffs, weaker demand, or a financial disturbance do if the policy assumption were kept fixed? It can make the cost of the risk visible and give policymakers a rationale for considering a change in stance.
A policy-response scenario asks a different question. If the shock occurs, how would the central bank react, and how would that reaction alter the path for inflation and output? The policy rate is no longer a passive label at the bottom of a table. It becomes an endogenous part of the scenario: the economic development influences policy, and policy feeds back into the economic development.
The BIS article gives a simple illustration. A demand shock that, holding other factors equal, would raise inflation by 2 percentage points over the next two years also prompts a higher policy rate. The higher rate reduces the rise in inflation by half. The scenario with the response therefore displays a much smaller forecast miss than the shock alone would produce.
That result can communicate commitment. It shows that the central bank would take action to meet its inflation objective rather than allow the full shock to pass through. But it can also create confusion. If the published inflation path ends close to the central scenario, an observer may ask why tighter policy is necessary. The response has dampened the visible symptom, so the communication can hide the size of the underlying disturbance and the cost of achieving the better outcome.
The problem is circularity. The shock changes inflation and GDP. Those variables enter the policy rule or the policymaker's judgment. The resulting rate change then affects demand, financial conditions, expectations, and eventually the same inflation and GDP figures used to justify the response. A displayed outcome is consequently a joint product of the shock, the model, the policy behavior assumed, and the feedback among them.
Reading that loop requires separating the starting disturbance from the mediators and the final outcome. The starting disturbance might be a demand surge. The mediators include the policy rate, borrowing conditions, spending, and expectations. The final inflation path depends on all of them. If a chart shows only the final path, a reader may attribute the result to a mild shock when it actually reflects a strong policy response, or attribute it to successful policy when the assumed rule simply suppresses the relevant variable by construction.
A common way to close the loop is to apply a policy rule that maps macroeconomic variables such as inflation or GDP growth to the policy stance. A rule estimated from past central-bank behavior has an advantage: it is relatively simple and transparent. A reader can see why a particular path for inflation or output produces a particular policy-rate path.
Transparency does not make the rule complete.