Fed's actions spoke louder than words in inflation fight, research shows

Federal Reserve's credibility in eyes of financial markets helped in its battle against inflation over past two years, but it h to be earned afresh with interest rate hikes that backed up policymakers' verbal promises to restore price stability, according to new research presented at 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, prompting markets to shift financial conditions faster and lowering inflation with a less serious hit to ecomic growth than would orwise be case.

While investors came to believe that US central bank under leership of Fed Chair Jerome Powell was serious about defending its 2 per cent inflation target, that belief only formed over time and after officials began raising policy interest rate in March of 2022 and accelerated rate hikes over that summer, researchers found.

"Forecasters and markets were highly uncertain about monetary policy rule prior to 'liftoff' and learned about it from Fed's rate hikes," ecomists Michael Bauer from San Francisco Fed, Carolin Pflueger from University of Chicago, and i Sunderam from Harvard Business School, found in ir research. "Substantial rate hikes were apparently necessary for perceptions to shift ... public did t fully understand Fed's strategy and policy rule prior to liftoff."

research serves as a warning of sorts against central bankers putting too much weight on power of "talk rapy" - or ability to influence ecomic outcomes with words and promises alone.

Earning public trust

Fed in recent years has been characterized by a surfeit of speeches and public comments by its officials, wher by he of central bank, or members of its presidentially-appointed Board of Goverrs, or its 12 regional bank presidents, under tion that more transparency is good for public accountability and makes policy more effective.

Fed officials in recent inflation battle often ted that public belief in ir commitment to inflation target would help on its own to lower pace of price increases, shorten time it took for tighter monetary policy to have an impact, and lower inflation with less dam to job market and or aspects of "real" ecomy.

researchers found, however, that while Fed under Powell eventually earned benefit of public trust, it also wasn't a given.

research used survey data to quantify how professional forecasters perceived Fed would respond to higher inflation, and found that even as prices began rising in 2021 expected Fed response to inflation was near zero.

While that could have been attributed to a number of factors, including a belief that inflation would ease on its own, researchers concluded it was actually because forecasters actually weren't sure how central bank would react.

After first rate increase in March of 2022, however, perceptions began to shift, with forecasters eventually expecting Fed to respond on an almost one-for-one basis to any rise in inflation.

change in perceptions coincided with policymakers shifting from initial quarter-percent-point move to first of four 75-basis-point hikes in June of 2022, and with a stern speech by Powell at that year's Jackson Hole conference that reaffirmed his intent to defend inflation target despite ecomic pain it might cause.

As market perceptions about Fed's sensitivity to inflation increased, "interest rates became significantly more sensitive to inflation data surprises," research found, ding that " increase in perceived inflation response likely aided transmission of monetary policy to real ecomy and improved Fed's inflation-unemployment treoff."

For future policymakers, researchers said, conclusion is clear: actions speak louder than words.

"Policy rate actions contribute to, and may even be necessary for, effectiveness of communication, particularly when uncertainty about monetary policy framework is high," y found, suggesting Fed's quarterly Summary of Ecomic Projections could be changed to make central bank's "reaction function" more explicit. "A timely policy rate response to inflation matters t only for influencing immediate financial conditions, but also for signaling that policymakers are serious."