The Federal Reserve’s credibility in the eyes of financial markets plays a crucial role in its battle against inflation, as shown by recent research presented at the Kansas City Fed’s annual research conference in Jackson Hole, Wyoming. A strong perception in financial markets that a central bank is committed to inflation control can make monetary policy more effective, leading to faster shifts in financial conditions and lower inflation with less impact on economic growth.
Investors came to believe in the US central bank under Fed Chair Jerome Powell’s leadership only after the officials began raising the policy interest rate and accelerating rate hikes. The public’s understanding of the Fed’s strategy and policy rule improved over time, as substantial rate hikes were necessary for perceptions to shift. This research highlights the importance of policymakers backing up verbal promises with actual interest rate hikes to restore price stability.
While the Fed has focused on public speeches and comments to enhance transparency and accountability, the researchers caution against relying too heavily on “talk therapy” alone to influence economic outcomes. Public trust in the Fed’s commitment to its inflation target eventually helped lower the pace of price increases and minimize damage to the job market and the real economy. However, earning public trust was not guaranteed and required concrete actions by policymakers.
Professional forecasters’ perceptions of how the Fed would respond to higher inflation changed significantly after the first rate increase in March of 2022. The Fed’s shift from quarter-percentage-point moves to more substantial rate hikes and Powell’s reaffirmation of defending the inflation target at the Jackson Hole conference further enhanced market perceptions. As market perceptions of the Fed’s sensitivity to inflation increased, interest rates became more responsive to inflation data surprises, improving the Fed’s inflation-unemployment tradeoff.
According to the researchers, future policymakers should prioritize actions over words when it comes to communicating monetary policy decisions. Policy rate actions contribute significantly to the effectiveness of communication, especially when there is uncertainty about the monetary policy framework. They suggest making the central bank’s “reaction function” more explicit in the quarterly Summary of Economic Projections to signal policymakers’ seriousness about defending the inflation target. Ultimately, timely policy rate responses to inflation are crucial for influencing financial conditions and signaling policymakers’ commitment to their objectives.
