What a Fed Debate 17 Years Ago Reveals About Its Rate Deliberations Now

The Fed is set to approve lifting its benchmark federal-funds rate by a quarter percentage point to a range between 5% and 5.25%, which would be its 10th consecutive increase.

For clues on how this debate could play out, it helps to look at how Fed officials discussed how to end a series of rate increases in 2006. The situation today isn’t directly comparable because inflation is much higher today than then, and unemployment is lower.

Moreover, that hiking cycle had been more gradual, giving officials more time to study the effects of their moves.

Officials faced a similar dilemma—when to signal more increases were possible and when to signal they were done. 

By the end of 2005, Fed officials had raised interest rates by a quarter percentage point at each policy meeting since the middle of 2004. Officials signaled that steady, quarter-point increases lay ahead by promising in their statement to lift rates at a “measured pace.”

By their November 2005 meeting, that phrase was growing dated. They were on track to raise the fed-funds rate above 4%, and they realized it could soon be time to stop.

Officials embarked then on discussions over how to signal their intentions while dealing with the inherent difficulty of using backward-looking economic data to set a forward-looking path. At their December 2005 meeting, transcripts show, then-Fed Chair Alan Greenspan told his colleagues it was plausible they might conclude raising rates the following month, in January 2006. 

At the January meeting, the Fed statement signaled a possible end to rate rises on the horizon by ditching the “measured pace” language. Instead, the statement said “some further policy firming may be needed.” Those words are almost identical to the formulation Fed officials used at their most recent gathering, in March of 2023.

But then, a funny thing happened on the way to a Fed pause: The economy and inflation in early 2006 proved more resilient than officials anticipated. Inflation—measured by increases in the core personal–consumption expenditures price index, which excludes volatile food and energy prices—would soon run above 2.5%. Officials raised rates at their March 2006 meeting and left their statement unchanged.

In May 2006, more Fed officials grew skeptical about the need to continue raising rates and wanted to stop, but a couple of others worried more about inflation and favored a larger half-point rate rise. Officials compromised by raising rates a quarter point. They softened their statement guidance to say that some further policy firming may “yet” be needed and added a new sentence: “The extent and timing of any such firming will depend importantly on the evolution of the economic outlook.”

Janet Yellen —then-president of the San Francisco Fed and now Treasury secretary—explained at the time why that change mattered, transcripts show. “The statement helps us get off the treadmill we’ve been on and enhances flexibility, but it doesn’t tie our hands into pausing in June if the data between now and then are so strong as to necessitate…a further move at that time,” she said at the May 2006 gathering.

In June 2006, the Fed made its final increase in that series, lifting the fed-funds rate to 5.25%, before an extended pause. Markets at the time were placing a high probability—roughly a five-in-six chance, according to interest-rate futures markets—that the Fed would continue to raise rates at the subsequent meeting in August because inflation was still firm.

Officials decided to signal a possible pause by dropping from their June policy statement the line that “some further policy firming may yet be needed” and tweaking the language around the “extent and timing” of any additional increases that might be needed.

The Fed didn’t tell the public as much about its intentions back then as it does now. There were no quarterly rate projections and no press conference with the chair. The Fed didn’t have a publicly stated 2% inflation goal. As a result, Mr. Bernanke argued for more clearly signaling a possible pause in the statement to remind investors the Fed wasn’t exclusively focused on inflation.

“There is a new chairman. They don’t know me. As far as they know, I am an inflation nutter,” he said, “and I want to make sure that they understand that output is one of our concerns.”

The question this week is how officials will approach this debate. One option would be for the Fed to tailor its policy statement more along the lines of the May 2006 iteration, when it held the door open to another rate rise in June.

The alternative would be a statement more like that in June 2006, when they approved another increase but signaled more strongly that it might have been their last for the series.

Matthew Luzzetti, chief U.S. economist at Deutsche Bank, said the Fed should go with the first option now to push back against market expectations that it will turn to rate cuts this year. “If they do explicitly recognize the potential for pausing, it will exacerbate the gap between the Fed and the market,” he said.

Vincent Reinhart, who was the top staff adviser most involved in wordsmithing statement proposals for the rate-setting committee in 2006, said the Fed should pick the second path.

“Their guidance language thus far has had an element of promise. But you don’t want to promise it if you’re not confident you’ll deliver,” said Mr. Reinhart, who is now chief economist at Dreyfus and Mellon.

Write to Nick Timiraos at [email protected]