“The U.S. economy is going through a rapid and significant slowdown — which will emerge in a significant change of tone across a variety of economic indicators relatively soon,” Carl Riccadonna and a team of economists at BNP Paribas wrote in a research note this week. After the Federal Reserve announced a rate hike on Wednesday.
As Ricadona noted, Fed Chair Jay Powell has been clear that the Fed is determined to do “just enough to restore price stability.” But it is difficult for the central bank to do the following: Federal Reserve governors have only a few toolsAnd they are not working perfectly.
A pair of new academic papers from the National Bureau of Economic Research’s economists analyze the Fed’s dilemma and the work of the economists who follow it. In one study, “perceptions about monetary policyResearchers Michael Bauer of the University of Hamburg, Caroline Flieger of the University of Chicago, and Adi Sundiram of Harvard Business School investigate how professional economic forecasters predict Fed actions.
These forecasters — economists and market strategists who work for institutions like Bank of America, for example — get paid to discern what the Fed will do before the central bank does. This was a much more difficult task before the era of transparency, when Fed governors rarely explained their thinking.
But even today, with Chairman Jay Powell holding press conferences to discuss how central bankers see economic data, it’s hard to know exactly what they’re planning and what the impact will be on the economy. This is critical, because “what matters for the success of monetary policy is not only the actual monetary policy framework used by policymakers, but also the understanding of that framework by the public,” the researchers wrote.
The researchers studied how forecasters’ predictions tracked what actually happened later.
“What we think is happening is, even these highly sophisticated professional forecasters, they don’t know exactly what the monetary policy framework really is,” said Pflueger, an assistant professor at the University of Chicago’s Harris School of Public Policy. “What people seem to do is learn from monetary actions.”
She said that when the Fed raises rates in a strong economy, analysts learn that the central bank cares about economic conditions and will respond accordingly. The researchers found that it takes forecasters six months to figure out what the Fed is doing, but at this point they can fairly infer the Fed’s intentions.
For bankers, the paper’s important finding is to look sharp, Pflueger said, “If you see the monetary policy framework changing, it could change more quickly than you think.”
The question John Cochran, an economist and senior fellow at Stanford’s Hoover Institution, asks in his working paper is how effective this framework is: “Can the Federal Reserve contain inflation without significantly raising interest rates?” The answer, he said, is “we honestly don’t know.”
In his view, it is “possible, but difficult” for the Fed to rein in inflation. That’s because spending on pandemic relief for the past two years is now over, so inflation will likely subside once the government stops spending so much money. But it is also possible, he said, that conventional economic wisdom is correct, and that the Fed will have to raise interest rates to be above the current rate of inflation before rates can fall.
Cochrane had a much darker view on the implications of his paper, “Expectations and neutrality of interest rates“For the banks,” he said, “I think the Fed is going to steadily raise interest rates until inflation subsides significantly. There is a lot of momentum in inflation. It took two years to really take off, and it will take some time to bring it down. So I think rates are going to be a lot higher than he expects.” Most people (and financial markets).”