Have Central Bankers Lost Their Power?
Evidence is revealing the power, limits, and confounding effects of monetary policy.Have Central Bankers Lost Their Power?
Edmon de Haro
Inflation chatter started heating up this spring, along with inflation itself. In April 2021, the US Consumer Price Index, which measures how fast prices change, rose at a 4.2 percent annual rate, more than double the usual target rate. Then in May, the inflation rate soared to 5 percent. With the worst of the pandemic seemingly easing, US consumers were apparently venturing out again and spending at a fast clip.
The figures took inflation watchers off guard. The Wall Street Journal’s editorial page noted that Federal Reserve chairman Jerome Powell had wanted some inflation but would likely be surprised by the force of April’s numbers, saying, “Powell’s inflation ship has come in, albeit more rudely than he probably wanted.”
Financial journalists and investors, always looking for signs of how the central bank will react to signs of inflation or deflation, kicked into high gear, trying to anticipate the timing of any Fed actions.
But consumers—who actually drive inflation—seemed unfazed, apparently already operating with the understanding that prices were rising fast, and would continue to do so. Homeowners remodeling their homes during the pandemic were aware of historically high lumber prices. Home cooks felt the impact on food prices. Buyers of both new and used cars saw prices surge due to a shortage of computer chips.
This diversion in inflation views between policy makers and consumers is notable and runs deep, says Chicago Booth’s Michael Weber. Central banks and shoppers are living, to some extent, in different worlds—focusing on different things, and forming expectations on the basis of those.
Monthly percentage change from 1 year prior
US Bureau of Labor Statistics; FRED, Federal Reserve Bank of St. Louis
And the gap in outlooks is potentially problematic, he explains. Arguably, the main job of the Fed is to keep inflation steady, and it does that in large part by influencing markets and consumers. But if consumers have significantly different ideas about inflation than the monetary-policy experts, they won’t see the institution as credible. That’s the challenge the central bank faces as it seeks to put the economy on more stable footing in the wake of the coronavirus crash and recession, but it could also have implications for the future of the institution.
“If the Fed says inflation is under 5 percent, but I think it’s 10 percent, I don’t have faith in the Fed,” Weber says. “That can be a slippery slope, and you can see how it could lead to the Fed losing some of its independence if politicians, hearing from the public, get involved.”
Central banks have a number of mandates, but in the United States, two are key: keeping prices stable and seeking maximum sustainble employment in the economy. Having stable prices boils down to managing inflation, for which the goal in the US is about 2 percent annually. Inflation hit double digits in the 1970s, sparking demonstrations by mothers and children outside grocery stores, and a weeklong boycott of meat, among other protests. But since then, there have been a few peaks and valleys during recessions and other global economic events. Otherwise, prices have been pretty reliable for American consumers, and Powell indicated in July that he expected the same going forward.
When inflation seems too low, or too high, the Fed tends to adjust interest rates to tap the gas or apply the brakes. When the economy needs a jolt, the Fed lowers rates, increasing spending and potentially inducing hiring. Raising rates makes borrowing more expensive and slows down spending, and by extension inflation.
However, in the past decade or so, the Fed has seemed to lose some of its influence in controlling inflation. The 2008–09 financial crisis led the Fed, for the first time in its history, to drop the interest rate effectively to zero in an effort to jump-start spending and revive the economy. Rates hovered near this zero lower bound until December 2015, when the Fed started adjusting them upward, only to have the COVID-19 pandemic crash global economies again and force rates back down. This has made the interest rate a much less useful tool for fighting inflation. The Fed can raise rates to stave off inflation if necessary, but there’s really no way to drop them further.
In times of crisis, the US Federal Reserve employs monetary-policy tools to help stabilize the situation. But in the past few years, there’s been some public speculation as to whether it has lost a crucial tool and, by extension, its control over short-term interest rates. “As Fed Loses Control of Overnight Rates, Blame Shifts to T-Bills,” blared a Bloomberg headline in 2018. The article quoted Credit Suisse Group AG analyst Zoltan Pozsar as saying, “Only the US Treasury can fix this, not the Fed.”
The concern that the Fed has lost control is overblown, according to Chicago Booth’s Quentin Vandeweyer. It can still move short-term rates, his research suggests, but it does so in a new way because of regulatory changes.
Thus, the Fed has embraced what watchers call unconventional monetary policy to maintain its influence. It has bought trillions of dollars’ worth of assets to get financial institutions moving and money flowing through the economy. And it has used forward guidance to tell the market, and the public, what it thinks is going on, with the goal of influencing their spending decisions. If the Fed says inflation could make their money less valuable in the future, for example, consumers are more likely to spend it today.
The Fed uses such strategies to try to maintain a grip on the economy. But ultimately, it’s important for the Fed and consumers to agree largely about the future. If they don’t, any decisions meant to jump-start the economy may be less effective, and the public’s perceptions could lead to decisions that run counter to the Fed’s goals‚ and perhaps push inflation or employment in the wrong direction.
If consumers disagree, the Fed’s asset purchases, for example, could still get the financial system moving—but people still might not want to borrow and spend. Similarly, they may tune out Fed statements. Research suggests that both of these things are happening.
The rate of inflation is the percentage rise of the cost of goods and services from one period to the next in an economy. In an economy with runaway inflation, a can of Coke might cost $1 on Monday, $1.25 on Tuesday, and $1.50 on Wednesday.
The Fed measures inflation with the Personal Consumption Expenditures price index, which takes into account the changes in cost for durable goods such as automobiles and appliances, nondurable goods including clothing and personal care supplies, and services.
But the Fed is specifically interested in core inflation. To get that, it strips out energy and food, both of which have particularly volatile prices, but are also likely to influence consumer expectations. The average American might buy a car or washing machine once every few years, if that often, so isn’t paying close attention to how much prices for those items rise, says Weber. But consumers regularly fill up their gas tanks and go grocery shopping, thus the prices for energy and food, which the Fed ignores, color many opinions about inflation.
The Fed isn’t wrong to want to evaluate inflation without those influences, notes Weber.
“It’s normal for consumers to use those gas and grocery price signals because we see them so frequently, but they’re certainly volatile and not representative of the consumption bundle we use to measure inflation,” he says.
But the Fed is wrong in some of the assumptions it holds about consumers, he adds. “Fed officials assume households are like robots and rationally gather all available information, listen to what the Fed is doing, and act accordingly. That’s just not how most people behave.”
Weber says Americans have had the luxury of being “rationally inattentive” for quite some time when it comes to monetary policy.
When Powell and his colleagues consider consumer behavior, they assume that people have well-anchored views of inflation—that is, if the Fed sets a target of 2 percent inflation each year, the general public will act and spend accordingly. For example, if inflation is high for a quarter, a well-anchored public won’t change its spending habits much or at all because it has and maintains faith in the goal of 2 percent inflation.
In this view of the world, the Fed’s statements carry a lot of weight. If the bank suggests that inflation could outpace its target, consumers would worry about their spending power. They would make some large purchases sooner than they might have otherwise, which could open up options for the Fed. With interest rates at or near zero, a bump in spending would push the economy toward higher inflation, which would allow the Fed to raise interest rates and tap the brakes. In that scenario, the Fed recovers its ability to influence the economy through rate increases and decreases.
But research suggests that this view is incorrect, in part because Americans aren’t paying close attention to what the Fed does or says. University of Texas’s Olivier Coibion, University of California at Berkeley’s Yuriy Gorodnichenko, and Weber surveyed more than 20,000 Americans in 2018 and asked what they expected the Fed’s inflation goal to be. Fewer than 20 percent answered correctly, while a whopping 40 percent thought the Fed was targeting 10 percent inflation, more than five times the actual level. This “suggests a pervasive lack of knowledge on the part of households about the objectives of the Federal Reserve,” the researchers write.
Executives, surveys indicate, are similarly situated. UC Berkeley PhD student Bernardo Candia, Coibion, and Gorodnichenko have since 2018 collected quarterly data from CEOs and senior business leaders at companies of all sizes. Executives, less than half of whom said they knew the Fed’s inflation target, also often expect inflation to be higher than the central bank predicts, they find, although individuals’ forecasts vary widely.
Both executives and consumers are influenced by what they see and experience. Work by Boston College’s Francesco D’Acunto, UC Berkeley’s Ulrike Malmendier, the Central Bank of Colombia’s Juan Ospina, and Weber finds that grocery prices—despite the Fed’s focus—have a big influence on consumers’ expectations about inflation. The researchers analyzed data from the Nielsen Datasets at Booth’s Kilts Center for Marketing, specifically consumer panel data gathered by a representative group of households about their purchases, and conducted surveys in 2015 and 2016 to establish that the average consumer expected inflation to rise nearly 5 percent over the next year. Their expectations were tied to the changes in prices of items they most often purchase at the grocery store.
Moreover, women and men in households tend to have different expectations of inflation, with women expecting higher inflation, according to D’Acunto, Malmendier, and Weber. Women, they argue, tend to be the primary grocery shoppers in their households, which exposes them more often to the very price signals the Fed deems unstable.
People’s expectations of inflation, captured here by the University of Michigan Surveys of Consumers, have historically been higher and more volatile than the realized core inflation rate, which has been a focus of the Federal Reserve.
Expected inflation rate versus the actual rate
US Bureau of Labor Statistics; FRED, Federal Reserve Bank of St. Louis; expectations data copyright University of Michigan Surveys of Consumers
“Because grocery prices are highly volatile, and consumers focus disproportionally on positive price changes, frequent exposure to grocery prices increases perceptions of current inflation and expectations of future inflation,” the researchers write. “The gender expectations gap is largest in households whose female heads are solely responsible for grocery shopping, whereas no gap arises in households that split grocery chores equally between men and women.”
The Fed’s expectations about inflation, determined on the basis of core inflation, may correctly signal future inflationary pressure for the overall economy. And though the Fed is more likely than consumers to be correct in making inflation expectations, it doesn’t really matter, says Weber, if the disconnect blunts the Fed’s abilities. It can’t use forward guidance as an effective policy tool unless it can get consumers on the same page.
Assuming that the Fed is correct about how it calculates inflation, it needs to do a lot of work to reach and educate consumers. But the Fed has a communications problem. For starters, research finds that it filters its messages through traditional media—to consumers who are barely noticing.
In the same study in which people overestimated the target inflation rate, Weber and his colleagues gave consumers simple statistics on inflation such as the most recent rate, the Fed’s inflation target, and the FOMC’s inflation forecast. (The 12-member Federal Open Market Committee is the body that votes on monetary-policy actions.) This information reduced the average household’s forecast of inflation by more than 1 percentage point, bringing it closer to the Fed’s projections. But consumers given a USA Today article summarizing all these same data adjusted their inflation expectations by half as much.
It’s possible, the researchers write, that consumers simply don’t trust Fed messages that have been distilled by traditional media. Indeed, they find that people generally have a low level of trust in the economic news delivered by newspapers, which ranked behind social media as an information source. Consumers perceived USA Today to be more credible than other national newspapers including the Wall Street Journal, New York Times, and Washington Post.
“Despite being written explicitly for the general public, this media transmission of the FOMC’s decision and motivation seems to have either dissipated the message or, more likely given that the article is much clearer than the FOMC statement, been discounted by households because of its origin,” write Coibion, Gorodnichenko, and Weber. “This suggests one reason why monetary policymakers have had so little success in affecting the inflation expectations of households: relying on the conventional media to diffuse their message to the public can be ineffective because many households no longer read newspapers and even if they do, individuals discount reports from the news media.”
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Communicating directly with the public is difficult, however. The Fed has been at times notoriously opaque in its messages to everyday Americans. Former Fed chairman Alan Greenspan, knowing that a misspoken word could send markets soaring or tumbling, prided himself on being overly technical in his communications. “If I turn out to be particularly clear, you’ve probably misunderstood what I said,” he jested in a 1988 speech at the Economic Club of New York.
Current chairman Powell has become the anti-Greenspan in that respect. At a town hall meeting in 2019, he said, “Federal Reserve policy affects everyone, and we need to work hard, and we do work hard, at trying to communicate in a way that doesn’t lapse into economic jargon, and so it can be understood by the interested public.”
But while Powell might be invested in having a better connection with consumers, many Americans are barely aware of the Fed. Although a 2013 Pew Research survey found that about three-quarters of Americans knew that the Federal Reserve is responsible for setting monetary policy, an Associated Press/GfK Knowledge Networks poll a year later indicated that about 70 percent found it difficult to understand those policies. And according to a 2019 Reuters/Ipsos poll, only 57 percent of Americans are familiar with the Fed, and only 28 percent believe it is an independent body—which it is.
Weber says Americans have had the luxury of being “rationally inattentive” for quite some time when it comes to monetary policy. In places such as Argentina—where the inflation rate was 54 percent in 2019 and 42 percent in 2020—inflation is on the minds of consumers daily. But in the US over the past three decades, realized inflation has been low and near its target, meaning consumers haven’t had to think about the value of their money. A dollar is worth a little less each year, but not by much.
“In Argentina or Ukraine, where prices are high and volatile, being uninformed about inflation is costly,” Weber says. “In the US, there’s no real cost to being uninformed about it.”
The good news for the Fed is that central banks can reach consumers, if they reach out correctly, research suggests. Weber, along with D’Acunto and Karlsruhe Institute of Technology’s Daniel Hoang, finds that consumers are more receptive to certain types of messages from central banks.
The researchers compared forward guidance from then European Central Bank president Mario Draghi, about the future path of monetary-policy rates, with a less-conventional statement: the preannouncement of higher future consumption taxes in Germany a year ahead of a tax rollout in 2007.
The first statement said that interest rates would remain low for the foreseeable future; the second said explicitly that prices would rise and articulated by how much. The goal for both was to spur consumer spending in the short run. Yet only the tax announcement led to more short-term spending, with the German public increasing durable-goods consumption 10 percent for the year.
“Although theoretically both policies should raise households’ inflation expectations and spending on impact, only unconventional fiscal-policy announcements produce these outcomes in the raw data. Forward-guidance announcements appear unable to manage expectations or spending plans,” the researchers write.
In another example, D’Acunto, Hoang, the Bank of Finland’s Maritta Paloviita, and Weber find that consumers are more swayed by messages that tell them the target that policy makers plan to reach rather than how they intend to get there.
The researchers compared the responses of readers to two tweets from Olli Rehn, governor of the Bank of Finland. In one, Rehn focused on a target, saying that the “European Central Bank will do whatever is necessary to minimize the financial damage to citizens caused by the corona crisis.” In another, he focused on the instrument for achieving that goal, announcing the €750 billion Pandemic Emergency Purchase Programme.
Those who saw the target tweet were more likely to believe that the ECB’s policies would benefit their households, and they expected their average monthly gross income to increase €70–€80 per month compared with a control group. The instrument tweet had no effect on consumer attitudes.
It’s not just the message that matters, but also the messenger. D’Acunto, the Swiss National Bank’s Andreas Fuster, and Weber gave randomized groups Fed forecasts—along with photos of the people on the FOMC, including a white male, a white female, and a Black male—and asked for individuals’ beliefs on unemployment expectations. Female and Black study subjects trusted the data more when made aware of female and minority representation on the committee. White male subjects didn’t change their forecasts with or without the information about committee representation.
“Overall, diversity salience appears to increase the FOMC’s ability to manage the expectations of underrepresented groups without any negative consequences on the expectations of overrepresented groups,” the researchers write.
But diversity is more than a messaging tool, and more of it could make the Fed better informed, not just more trustworthy. Weber says that diversity on the FOMC could change policy decisions, as members would bring different experiences and perspectives to discussions about issues such as unemployment. Say the Fed is considering raising interest rates because overall unemployment is low and it sees higher inflationary pressures on the horizon. The unemployment rate of Black Americans tends to be higher than that of white Americans, and would a more diverse FOMC consider leaving rates low a little longer to push for better employment numbers in the Black community?
The Fed has been seeking outside opinions as part of a listening tour it has billed Fed Listens. At each of a series of events in 2019 and 2020, senior Fed officials gave only brief remarks and spent the rest of the time listening to and asking questions of members of the public, including small-business owners, residents of low- and moderate-income communities, and retirees, among others.
The listening tour and other outreach efforts may help the bank refine its message and presentation, which research finds also has power. Jamaica has worked with popular reggae singers, putting out songs about inflation to educate Jamaicans. A 2019 video by reggae singer Tarrus Riley, widely seen as effective, has more than 340,000 views on YouTube.
In the US, the Cleveland Fed is also reaching into popular culture. In June, it released three videos featuring LEGO people to explain what inflation is and why consumers and the Fed care about it. In two days, the videos attracted almost 15,000 views. But even with LEGO helpers, the Fed has a lot of work to do to reach most Americans and convince them its inflation view is the correct one.
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