Research shows that the Fed's actions in the fight against inflation were louder than its words

(MENAFN- Khaleej Times) The Federal Reserve's credibility in the eyes of financial markets helped it fight inflation over the past two years, but that credibility had to be earned again through interest rate hikes that backed up policymakers' verbal promises to restore price stability, according to a new study presented at the Kansas City Fed's annual research conference in Jackson Hole, Wyoming.

There is a strong belief in financial markets that a central bank committed to controlling inflation can conduct monetary policy more effectively, leading to a faster change in financing conditions in the markets and a reduction in inflation without having a more severe impact on economic growth than would otherwise be the case.

While investors gradually came to believe that the Federal Reserve, led by Fed Chairman Jerome Powell, was serious about defending its 2 percent inflation target, that belief only took shape over time, after policymakers began raising interest rates in March 2022 and accelerated rate hikes over the summer, the researchers found.

“Forecasters and markets were highly uncertain about the Fed's policy direction before the launch and learned this from the Fed's rate hikes,” economists Michael Bauer of the San Francisco Fed, Carolin Pflueger of the University of Chicago and Adi Sunderam of Harvard Business School noted in their study. “It appears that significant rate hikes were needed to change perceptions… The public did not fully understand the Fed's strategy and policy before the launch.”

In a sense, the research findings also serve as a warning to central bankers who place too much emphasis on the power of “talk therapy” – that is, the ability to influence economic outcomes with words and promises alone.

Gaining public trust

In recent years, the Fed has been characterized by a flurry of speeches and public comments by its officials—whether the Fed Chairman, other members of the President-appointed Board of Governors, or the 12 presidents of the regional banks—embracing the idea that greater transparency would promote public accountability and make policy more effective.

In the recent battle over inflation, Fed officials have frequently stressed that public confidence in their commitment to meeting their inflation target alone will help slow the pace of price increases, shorten the time it takes for monetary tightening to take effect, and reduce inflation without harming the labor market and other aspects of the “real economy.”

However, the researchers found that while the Fed under Powell ultimately gained public trust, this was not a given.

The study used survey data to quantify professional forecasters' assessment of the Fed's response to higher inflation, finding that even as prices began to rise in 2021, the Fed's expected response to inflation was close to zero.

While a number of factors could be responsible for this, including the assumption that inflation would subside on its own, the researchers concluded that it was actually because forecasters were unsure how the central bank would respond.

However, after the first rate hike in March 2022, perceptions began to change, and forecasters eventually expected the Fed to respond almost one-to-one to any increase in inflation.

The change in perception coincided with policymakers moving away from the initial quarter-percentage-point increase to the first of four 75-basis-point increases in June 2022. In addition, Powell delivered a stern speech at the Jackson Hole conference that same year reiterating his intention to defend the inflation target despite the economic problems it would bring.

As market perceptions of the Fed's inflation sensitivity increased, “interest rates became significantly more sensitive to surprises in inflation data,” the study said. It also said that “the increase in perceived inflation responsiveness likely supported the transmission of monetary policy to the real economy and improved the Fed's inflation-unemployment ratio.”

For future political decision-makers, the conclusion is clear: actions speak louder than words.

“Policy rate actions contribute to, and may even be necessary for, communication effectiveness, particularly when uncertainty about the monetary policy framework is high,” they noted, suggesting that the Fed's quarterly summary of economic forecasts could be changed to make the central bank's “response function” more explicit. “A timely policy rate response to inflation is important not only to influence immediate financial conditions but also to signal that policymakers mean business.”

MENAFN25082024000049011007ID1108598869

Disclaimer:
MENAFN provides the information “as is” without warranty of any kind. We assume no responsibility or liability for the accuracy, content, images, videos, licenses, completeness, legality or reliability of the information contained in this article. If you have any complaints or copyright issues related to this article, please contact the provider above.