Rate cuts on the horizon: New research argues that the key factors in restoring the Federal Reserve’s credibility and controlling inflation were, to a large extent, the aggressive interest rate increases of the past two years. One study underlines that the Fed’s public promises played their role, but it was the actual actions, in particular the interest rate hikes, that really sealed market confidence and increased the power of monetary policy.
The question is to what extent financial markets’ perception of the Fed’s commitment to controlling inflation determined the outcome of monetary policy. That perception was, as the authors note, fuzzy at first and then fixed; fuzzy at first and then fixed only after the Fed began raising interest rates in March 2022 and continued to do so aggressively through the summer.
Prior to these rate hikes, analysts and markets remained in limbo regarding the Fed’s response to rising inflation. Researchers believed that large interest rate increases would be needed to change these expectations and clearly indicate that the Fed was targeting a 2% inflation rate. Before the clear influences of the Fed’s actions became apparent, there was much uncertainty about the Fed’s goals and business approach.
It is clear from the study that mere verbal commitments have limitations in terms of power to achieve economic outcomes. Although there were many speeches and public statements of commitment to controlling inflation by Fed officials, it was the actual policy changes that convinced the markets of the Fed’s resolve. The Fed’s credibility improved markedly after the Fed made further rate hikes of +75 basis points and Fed Chair Powell’s stern comments to stay the course and address the inflation problem at the 2022 Jackson Hole conference even if it means causing economic unrest, paving the way for more:.
The researchers argue that this is important because, going forward, policy concerns are best communicated through concrete actions, especially in the absence of a monetary policy framework. To further solidify the public’s view of stated commitments, they suggest that the Fed’s Quarterly Summary of Economic Projections may need to be revised to make its response to economic conditions more specific and to take steps that further reinforce the Fed’s commitment to its inflation goals.
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