The credibility of the Federal Reserve helped financial markets in the central bank’s multiyear battle against inflation, but it had to back up its verbal promises to restore price stability with rate cuts, according to new research presented at the Kansas City Fed’s annual research conference in Jackson Hole, Wyoming.
The research found that a strong perception in financial markets that a central bank is committed to controlling inflation can make its monetary policy more effective, prompting markets to shift financial conditions faster and lowering inflation with a less serious hit to economic growth than would otherwise be the case.
Although investors came to believe that Fed Chair Jerome Powell and other policymakers were serious about maintaining the central bank’s 2% inflation target, that belief only formed over time and after officials began raising the benchmark federal funds rate in March 2022 and accelerated the hikes that summer, the researchers found.
Inflation surged to a 40-year high of 9.1% in June 2022, which prompted the Fed to raise the federal funds rate to a range of 5.25% to 5.50%, the highest level in 23 years. With the rate of inflation having slowed to 2.9%, the Fed is expected to cut interest rates in September for the first time since the onset of the COVID pandemic in March 2020.
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“Forecasters and markets were highly uncertain about the monetary policy rule prior to ‘liftoff’ and learned about it from the Fed’s rate hikes,” economists Michael Bauer from the San Francisco Fed, Carolin Pflueger from the University of Chicago and Adi Sunderam from Harvard Business School found in their research.
“Substantial rate hikes were apparently necessary for perceptions to shift… The public did not fully understand the Fed’s strategy and policy rule prior to liftoff,” they wrote.
The research serves as a form of warning against central bankers putting too much emphasis on the power of “talk therapy” – the ability to influence economic outcomes with words and promises alone.
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Federal Reserve officials often noted during the recent inflationary cycle that public belief in policymakers’ commitment to the 2% inflation target would help on its own to slow the pace of price increases, reduce the time it took for tighter monetary policy to have an impact, and lower inflation with less damage to the job market and other aspects of the “real” economy.
However, the researchers found that while the Powell-led Fed eventually earned the benefit of public trust, it wasn’t a given. Researchers used survey data to quantify how professional forecasters perceived the Fed would respond to higher inflation, and they found that even when prices began rising in 2021, the expected Fed response to inflation was near zero.
While that could have been attributed to other factors, including a belief that inflation would ease on its own, researchers concluded it was actually because forecasters weren’t sure how the Fed would react. In the wake of the Fed’s initial rate increase in March 2022, perceptions began to shift and forecasters eventually began expecting the Fed to respond to any rise in inflation with a corresponding rate hike.
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The change in forecasters’ perceptions coincided with policymakers shifting from the initial quarter percentage-point rate hike to the first of four 75-basis-point hikes in June 2022. Powell delivered a stern speech at that year’s Jackson Hole conference that reaffirmed his intent to defend the inflation target despite the economic pain that higher rates might bring.
Researchers found that as market perceptions about the Fed’s sensitivity to inflation increased, “[I]nterest rates became significantly more sensitive to inflation data surprises” and that “the increase in the perceived inflation response likely aided the transmission of monetary policy to the real economy and improved the Fed’s inflation-unemployment tradeoff.”
“Policy rate actions contribute to, and may even be necessary for, the effectiveness of communication, particularly when uncertainty about the monetary policy framework is high,” the researchers found, suggesting the Fed’s quarterly Summary of Economic Projections could be changed to make the central bank’s “reaction function” more explicit.
“A timely policy rate response to inflation matters not only for influencing immediate financial conditions, but also for signaling that policymakers are serious,” they added.
The Federal Reserve’s Open Market Committee is scheduled to hold its next meeting on Sept. 17-18, when policymakers are expected to announce an interest rate cut.
Reuters contributed to this report.
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