Fed’s actions weighed more heavily than words in taming inflation, researchers say

credibility Federal Reserve The move helped financial markets in the central bank’s years-long battle against inflation, but it had to back up its verbal promises to restore price stability with interest rate cuts, according to new research presented at the Kansas City Federal Reserve’s annual research conference in Jackson Hole, Wyoming.

Research has found that a strong perception in financial markets that a central bank is committed to controlling inflation can make its monetary policy more effective, leading markets to shift financial conditions faster and lower inflation with less of a negative impact on economic growth than might otherwise be the case.

Although investors have come to believe that Federal Reserve Chairman Jerome Powell The researchers found that although the Fed and other policymakers were serious about maintaining the central bank’s 2% inflation target, that belief only took shape over time and after officials began raising the benchmark federal funds rate in March 2022 and accelerating increases that summer.

Inflation hit a 40-year high of 9.1% in June 2022, prompting the Federal Reserve to raise the federal funds rate to a range of 5.25% to 5.50%, the highest level in 23 years. With inflation slowing 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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In their research, economists Michael Bauer of the Federal Reserve Bank of San Francisco, Caroline Pflueger of the University of Chicago, and Adi Sundaram of Harvard Business School found that “forecasters and markets were largely uncertain about the monetary policy rule before ‘takeoff’ and learned about it from the Fed’s interest rate hikes.”

“It was apparently necessary to raise interest rates significantly to change perceptions…and the public did not fully understand the Fed’s strategy and policy rules before the rate hike,” they wrote.

The research serves as a kind of warning against central bankers placing too much emphasis on the power of “talking therapy” – the ability to influence Economic results With words and promises only.

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Markets expect an interest rate cut in September. (Angela Weiss/AFP via Getty Images/Getty Images)

Fed officials have often pointed out during the recent inflation cycle that public faith in policymakers’ commitment Inflation target 2% Raising interest rates would in itself help slow the pace of price increases, shorten the time it takes for monetary policy tightening to take effect, and lower inflation with less damage to the labor market and other aspects of the “real” economy.

However, the researchers found that while Fed led by Powell But while the Fed eventually gained public trust, it wasn’t a given. Researchers used survey data to measure how professional forecasters perceived the Fed’s response to rising inflation, and found that even when prices started rising in 2021, the Fed’s expected response to inflation was close to zero.

While this could have been attributed to other factors, including the belief that inflation would decline on its own, the researchers concluded that it was actually because forecasters were unsure about how the Fed would react. Following the Fed’s initial rate hike in March 2022, perceptions began to change and forecasters eventually began to expect the Fed to respond to any rise in inflation with a corresponding rate hike.

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Federal Reserve Chairman Jerome Powell, left, said during his speech in Jackson Hole that progress in returning inflation to 2% means it’s time to make monetary policy less restrictive. (Natalie Bering/Bloomberg via Getty Images/Getty Images)

The shift in forecasters’ perceptions coincided with policymakers shifting from an initial 1 percentage point rate hike in the first quarter to the first of four 75 basis point increases in June 2022. Powell delivered a hawkish speech that year. Jackson Hole Conference This reaffirmed his determination to defend the inflation target despite the economic pain that higher interest rates may bring.

The researchers found that as market perceptions of the Fed’s sensitivity to inflation increased, “[I]“Interest rates have become significantly more sensitive to inflation data surprises” and that “the increase in perceived responsiveness to inflation has likely helped transmit monetary policy to the real economy and improved the Fed’s performance.” The trade-off between inflation and unemployment“.”

“Interest rate actions contribute to, and may be necessary for, effective communication, especially when uncertainty about the monetary policy framework is high,” the researchers found, suggesting that the Fed’s quarterly summary of economic projections may be changed to make the central bank’s “reaction function” more visible.

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“A rapid response of interest rates to inflation is important not only to influence immediate financial conditions, but also to signal that policymakers are serious,” they added.

The Federal Reserve’s Open Market Committee is scheduled to hold its next meeting on September 17-18, when policymakers are expected to announce an interest rate cut.

Reuters contributed to this report.