Two recent studies shed light on how Americans receive and act on monetary policy information, such as inflation forecasts, from the Federal Reserve.
One paper indicates the news media has not been the most effective vehicle for Americans to receive policy pronouncements from the nation’s central bank. Its key takeaway: People’s inflation expectations more closely align with reality when they consider official Federal Reserve statements conveying inflation forecasts, rather than news articles covering those statements.
People also adjust their spending patterns based on their inflation expectations, the research finds. If they think prices will go up in the future, they spend more now.
The other paper shows that certain racial minorities and women trust some leaders at the nation’s central bank more than others. Its key takeaway: Unemployment expectations of Black people and women more closely align with reality when they receive unemployment forecasts from Federal Reserve leaders who look like them.
It’s yet more evidence that trusted messengers matter in different contexts, including politics, health and economics. Both studies offer food for thought for business journalists considering who their audiences are and how to report on monetary policy.
The rise of ‘forward guidance’ on inflation forecasts and other monetary policy
Financial markets have historically been the main audience for Federal Reserve policy communications, according to the authors of “Monetary Policy Communications and their Effects on Household Inflation Expectations,” forthcoming in the Journal of Political Economy.
The U.S. central bank strives to telegraph its policy moves, such as interest rate hikes, to sellers and buyers of bonds, equities and loans — and firms that provide analytics and forecasting to help investors predict how those markets will move.
“Forward guidance” refers to the Federal Reserve’s communication with the public about its intentions. The central bank has used forward guidance since the early 2000s. But transparency wasn’t always in fashion at the Federal Reserve. Former Chair Alan Greenspan tried to avoid rattling markets through opacity, rather than clarity. In 1987 he told Congress: “Since I’ve become a central banker, I’ve learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.”
Greater transparency arrived after markets reacted poorly to unexpected policy announcements. For example, Greenspan in early 1994 issued a brief statement explaining the central bank would raise interest rates for the first time since 1989. Back then, the Federal Reserve’s communication to the public was almost non-existent, compared with today. Minutes from key meetings were not released until months later, and the Federal Reserve did not issue statements following meetings. (Minutes are now released about two weeks after major meetings.)
In fact, Greenspan had never before issued a post-meeting statement, according to a 2015 FEDS Notes article. Investors didn’t see the statement or the rate increase coming. They read Greenspan’s statement, and other data releases during the year, as indicating higher inflation and slower economic growth ahead. Interest rates on certain Treasury bonds increased from roughly 5.7% in January 1994 to 7.9% in November — a 39% rise over the course of the year following three years of monthly yields trending downward.
Investors were telling the government that if the economy was going to slow down and the dollar was going to lose value relatively quickly, they wanted better returns for their bond purchases. This is one example of why the Federal Reserve now actively tries to avoid spooking markets and has expanded its public communication efforts.
The central bank in recent weeks has been saying it will likely raise interest rates following a meeting of top leaders scheduled for mid-March, and perhaps several times throughout the year, in order to combat high inflation that continues despite previous forecasts indicating rising prices would be “transitory.”
When journalists report that the Federal Reserve plans to raise interest rates, that’s referring to the central bank raising the federal funds rate. This is the interest rate commercial banks charge each other when they trade money held at Federal Reserve banks. Simply put, banks with extra cash lend to banks that need cash. Higher interest rates for consumers are an expected byproduct of raising the federal funds rate — it’s a calculated move from the central bank.
When interest rates are low, spending tends to go up. When rates are high, spending decreases. Adjusting the federal funds rate is a way for the central bank to influence the amount of money flowing through the economy — which is why the Federal Reserve cares that its forward guidance gets through the public, too.
Think of a homeowner planning to finish their basement. If it’s cheap to get a loan, the homeowner will likely move forward with the renovation. They’d hire a local contractor, spurring job growth. Painters, plumbers and carpenters doing the work would have more money in their pockets to spend on other goods and services.
But if it’s expensive to borrow money, the household might put off the renovation, at least until interest rates fall. The jobs that would have been created from the renovation never materialize in that moment. Businesses, too, are more willing to borrow to expand or hire workers when interest rates are low.
Through press releases and statements, the Federal Reserve has recently been telling financial markets it intends to tame inflation by pushing interest rates up so overall demand for goods and services cools down.
The Federal Reserve has been successful in communicating policy intentions to financial markets, in the sense that those markets do respond to forward guidance. According to a March 2021 paper in the Journal of Monetary Economics examining the effects of Federal Reserve announcements from July 1991 to June 2019, forward guidance and certain asset purchases “had substantial and highly statistically significant effects on Treasury yields, corporate bond yields, stock prices, and exchange rates, comparable in magnitude to the effects of the federal funds rate,” during economically stable periods.
But the central bank has been less successful in communicating to businesses and the general public, according to the authors of the forthcoming paper. In countries like the U.S. that typically enjoy low inflation, businesses and households “seem unaware of even dramatic monetary policy announcements, and more generally display almost no knowledge of what central banks do,” the authors write.
Survey takers trust the Fed more than traditional news
Federal Reserve communications to the public aim to “anchor” inflation expectations, meaning the general public should have an inflation number in mind that aligns with actual and proposed central bank policy.
“One way to think about anchoring expectations is you have high trust in a central bank,” explains Michael Weber, an associate professor of finance at the University of Chicago and an author of the forthcoming paper in the Journal of Political Economy. “And short-run expectations could be fluctuating, but in the long run, on average, the central bank will do its job and you can expect average inflation to be around 2%.”
To identify ways the Federal Reserve could better educate the public on its functions and policies, the authors conducted a randomized controlled trial in which they surveyed nearly 20,000 U.S. consumers reflective of the nation’s overall demographics. That’s a large sample for a consumer survey — the New York Federal Reserve’s monthly Survey of Consumer Expectations includes a rotating panel of 1,300 people, though it has the advantage of being regularly administered, so it captures changes over time.
The authors of the paper first asked participants what they thought inflation had been over the previous year. Then, they asked participants for their inflation forecast for the coming year. But before making predictions, eight groups received some additional information. A ninth control group received no extra information. Randomized controlled trials are rare in economic research, though they have become more popular over the past four years.
A roughly equal number of participants were randomly presented with one of the following pieces of information before making their inflation predictions:
- The actual inflation rate over the past year.
- The Federal Reserve’s general inflation target of 2%.
- A specific inflation forecast from the Federal Reserve.
- A longer statement from the central bank on inflation expectations.
- A USA Today article covering the Federal Reserve’s inflation forecast.
- Gas price inflation over the prior three months.
- The most recent unemployment numbers.
- U.S. population growth over the past three years — a non-economic data point acting as a placebo. The population growth figure was 2%. The idea was to see if being shown a figure identical but unrelated to the Federal Reserve’s target inflation rate would influence participants’ forecasts.
All of the above were real-world forecasts, statements and news stories. The survey took place in 2018, before the current spate of high inflation.
Setting expectations and educating people and businesses on how Federal Reserve policy works is particularly important when economic conditions change drastically. This is because perception matters when it comes to inflation. Some businesses place their orders weeks or months in advance. Those retailers take a best guess at how inflation might affect the number of goods they sell, and place their orders accordingly.
When inflation is stable, that guessing game is made a little easier. For now, Weber says, “people tend to put more weight on positive rather than negative price changes. Even if inflation went down now, people wouldn’t come down with their inflation expectations.” It’s a notion supported by Federal Reserve research.
All participants surveyed were also asked what they thought was the Federal Reserve’s ideal inflation rate, before receiving any additional information. Nearly 40% of respondents answered 10%, far off the actual answer of 2% and suggesting “a pervasive lack of knowledge on the part of households about the objectives of the Federal Reserve,” the authors write.
The groups receiving the first three treatments — the actual inflation rate over the past year, the Federal Reserve’s inflation target and the central bank’s inflation forecast for the coming year — reduced their inflation forecasts by about 1% compared with the control group.
Participants in the gas price group increased their inflation expectations by about 1.5% compared with the control group. (Gas prices had risen at an 11% clip over the three months before the survey.) The longer Federal Reserve statement also had a relatively large effect. That group reduced inflation expectations by about 1.2%. The unemployment rate information led to a downward revision of 0.3% among that group.
The placebo group, which received the information about recent population growth, reduced their inflation forecasts by about 0.3%, relative to the control group.
The USA Today group reduced their inflation expectations by about 0.5%, “less than half the effect of any of the other inflation-related treatments,” the authors write. Participants with relatively less education and less income, respectively, tended to especially give little credence the USA Today article. The authors continue:
“The major caveat is that relying on the media to transmit the central bank’s message is unlikely to be very successful: Not only do many households not follow news about monetary policy but even when exposed to news articles focusing explicitly on monetary policy decisions, these news articles seem to be heavily discounted by the public due to their source.”
In follow up surveys, inflation expectations of participants in any of the treatment groups halved three months later. Those inflation expectations fully converged with the control group six months on. In other words, information on inflation predictions at a single point in time had little lasting effect on participants’ inflation perceptions.
“These results suggest central banks cannot rely on one-off messages but have to develop a repeated communication strategy to the extent that central banks intend to manage consumer expectations through communication,” the authors write.
Because participants were recruited from the Nielsen Homescan Panel, the authors accessed retail scanner data on select items participants purchased, like food and other regular consumer goods, in the months after the survey. Generally, participants who expected higher inflation over the coming year spent more — meaning individuals’ own perceptions of future inflation affected their real-world spending. The authors also asked about spending in their follow up surveys and found similar results.
Why does the Fed target 2% inflation? The Federal Reserve publicly adopted a target annual inflation rate of 2% in Jan. 2012 in order to “firmly anchor longer-term inflation expectations,” Kansas City Federal Reserve researchers Brent Bundick and A. Lee Smith wrote in March 2021. Inflation in the U.S. settled around 2% in the mid-1990s, and St. Louis Federal Reserve President James Bullard has argued that the central bank behind the scenes has targeted that rate ever since. Explicit inflation targeting has been a global trend for central banks since the early 1990s, while 2% target inflation remains the “international standard,” Bullard wrote in Sept. 2018. As Federal Reserve Chair Jerome Powell explained in an Aug. 2020 speech, inflation targeting “was also associated with increased communication and transparency designed to clarify the central bank’s policy intentions. This emphasis on transparency reflected what was then a new appreciation that policy is most effective when it is clearly understood by the public.” Indeed, the Federal Reserve in Jan. 2016 clarified in a statement that the 2% target is fluid. Fluctuations are normal, however the central bank would be “concerned if inflation were running persistently above or below this objective.” This is where monetary policy comes into play. When inflation is running hot, the Federal Reserve typically raises interest rates to try to bring inflation down closer to 2%.
Messengers matter
Public trust is not just linked to how the Federal Reserve communicates but who is communicating. A Sept. 2021 National Bureau of Economic Research paper, “Diverse Policy Committees Can Reach Underrepresented Groups,” also uses a randomized controlled trial to explore which bank leaders are trusted public messengers.
Much news coverage has focused on the importance of trusted messengers during the pandemic, particularly around vaccine hesitancy. The same can hold true when it comes to how the public understands the health of the U.S. economy.
The authors used survey firm Qualtrics to recruit 9,140 participants broadly representative of the U.S. population by gender, age, education level and geography. Black adults were slightly over-represented to ensure the authors had enough data from that group to draw informative conclusions.
Participants were first asked for their estimates of unemployment and inflation rates in the U.S. They were then shown Federal Reserve forecasts for those economic measures alongside a randomly selected picture, name and title of one of three system leaders:
- Tom Barkin, a white man in charge of the Federal Reserve Bank of Richmond.
- Raphael Bostic, a Black man who heads of the Federal Reserve Bank of Atlanta.
- Mary Daly, a white woman and top leader at the Federal Reserve Bank of San Francisco.
All three served as non-voting members during the June 2020 meeting of Federal Open Market Committee, which sets monetary policy for the country. The authors presented participants with forecasts from that meeting. A control group received a few lines about how the Federal Reserve operates and the demographic characteristics of regional and federal bank leadership.
There are no Hispanic people in equivalent leadership roles in the Federal Reserve System, so the authors could not test for that demographic group.
White women were more likely to report unemployment expectations more closely anchored to official forecasts when shown pictures of Bostic or Daly. The same held for Black participants, and the effects were “particularly large for Black women, who respond most strongly to Ms. Daly,” the authors write. Predictions from white men and Hispanic participants were largely unaffected by the messenger’s demographics.
“Crucially, women and African Americans, they become more interested in incorporating information from the Fed in their own economic plans moving forward, whereas the group over-represented before, white men, doesn’t react in a negative way,” says Boston College assistant professor of management Francesco D’Acunto, one of the authors of the paper along with Weber and Andreas Fuster, an associate professor of finance at the Swiss Finance Institute, EPFL.
Results for inflation expectations were by and large similar to the unemployment expectations, but the authors do not draw as definitive conclusions for that part of the study. The reason is that results for inflation expectations were less consistent. Some people’s inflation expectations were greatly affected by the messenger, while others not much at all. Whereas for unemployment predictions, entire groups — such as Black women — responded strongly.
“Inflation, until basically just a few months ago, was very, very low,” D’Acunto says. “People were not even thinking about the implications of inflation for their earnings and real versus nominal values. If we would replicate our study today that would be very interesting to see what happens, when people are much more aware now.”
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