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Why Central Banks Need to Change Their Message
The US and European central banks thought they could manage their economies by bringing their secretive plans for interest-rate regulation into the light. But they didn’t account for an unreceptive public.
- November 26, 2019
- CBR - Public Policy
A lot of people don’t have a clue what central banks do, much less how the institutions’ ever-changing interest-rate targets ought to affect their household financial decisions. Recent studies, including several by Chicago Booth researchers, find Americans and Europeans oblivious to or indifferent to the targets’ implications.
This is a serious problem for policy makers. For a decade, monetary policy in many developed economies has relied heavily on forward guidance, a policy of broadcasting interest-rate targets that works only if the public knows and cares what its central bankers say.
“The effects of monetary policy on the economy today depend importantly not only on current policy actions, but also on the public’s expectation of how policy will evolve,” said Ben Bernanke, then chairman of the US Federal Reserve, in a speech to the National Economists Club in 2013. At critical times since 2008, forward guidance has been the Fed’s and the European Central Bank’s go-to tool for revitalizing their ailing economies and holding off widespread depression.
Forward guidance usually involves central banks announcing their plans for interest rates, which traditionally were guarded as state secrets. The openness is intended to spur investors, businesses, and households to make spending and savings decisions that will bolster the economy; typically, to spend more money during economic slowdowns and to save more when the economy is expanding.
Chicago Booth’s Michael Weber and his research colleagues, in several studies, tested the basic assumption that households will respond to forward guidance, and find it flawed. Most people, the researchers conclude, generally do not make spending and savings choices on the basis of inflation expectations. In personal financial decisions—for example, to pay or borrow money for a boat, refrigerator, or renovations, or to sock away funds for rainy days—words from central bankers hardly register.
Why don’t more people respond to interest-rate news? In two of the studies, Weber and his coresearchers blame a lack of cognitive ability. Men who score at or below the median on IQ tests appear less likely to process and act on central-bank news in ways that would benefit their own household accounts and the overall economy, according to the studies, which Weber conducted with Boston College’s Francesco D’Acunto, Daniel Hoang of Karlsruhe Institute of Technology, and Maritta Paloviita of the Bank of Finland.
The researchers point out that low IQ is not the same as a low level of education, which they find, along with income, age, and other demographics, to be unrelated to interest-rate reactions.
Policy makers have struggled to understand why many individuals make economic decisions against their own best interests, such as ignoring potential tax breaks or unnecessarily carrying credit-card balances. Weber’s work on inflation expectations follows other research that addresses the conundrum by analyzing how individuals form economic expectations and act on them.
Research suggests central banks have yet to put forward guidance into language that motivates the public to act.
But consumers may not be wholly at fault. The way that central banks disseminate their interest-rate announcements also may limit public responses to the news, according to Olivier Coibion of the University of Texas at Austin, Yuriy Gorodnichenko of the University of California at Berkeley, and Weber. The researchers tested reactions to an article about Fed inflation news in USA Today, a widely circulated newspaper they consider less likely to be viewed as partisan by readers than other publications. Their findings suggest that USA Today articles that simplify Fed inflation news and explain its implications are doing little to change household spending.
These findings test policy makers, as well as economic forecasting generally. The most popular models for forecasting the economy’s response to monetary- and fiscal-policy moves assume that people will use the new information. If the announcements confound or bore the public, neither the forecasts nor the policies they support have much chance of success.
The Fed does little to directly address consumers’ understanding of monetary policy. It publishes consumer guides about mortgages, foreclosures, and a few other topics, but it does not prioritize speaking to the general public. The Fed’s increased openness and its push toward anchoring inflation expectations means that it publishes more-decisive words, more often, in statements, speeches, and interviews, but these are almost always aimed at financial markets. The Fed relies on the media to attract the public’s attention to these statements.
From proud incoherence to Fed-speak
For decades, the world’s central bankers cloaked deliberations in secrecy. On the rare occasions they publicly mentioned interest rates or economic conditions, they spoke in purposely ambiguous terms, largely for fear of politicizing the decision-making process. Professional investors, a group obsessed with both topics, studied those words like tea leaves. But a quote from then Fed chairman Alan Greenspan in 1987 captured his pride in that impenetrable verbiage: “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.”
If a lot of people don’t adjust their spending according to central-bank inflation announcements, as research suggests they don’t, some of the most respected economic forecasts in the world—used by the US Federal Reserve, the European Central Bank, and others—cannot be accurate.
The common models employ as a central feature the Euler equation, a mathematical formula that describes a trade-off between doing something now and doing it later. This “intertemporal substitution” that the equation describes relates to consumption, and the controlling variable is household inflation expectations that the central bank influences through its inflation target. In the formula, as the inflation target rises, consumption increases. The size of the change helps determine predictions for a broad range of economic components, from real-estate prices to GDP growth.
Consumers do react with some predictability to increases and decreases in real interest rates. For example, mortgage rates are largely determined by the Fed’s short-term interest rates; when the rates drop, new mortgages usually rise.
But the forecasting becomes less accurate as the central bank tries to predict consumer responses to interest rates that they do not yet see. During and after the Great Recession, the models predicted US consumers would increase spending on the basis of Fed forward guidance, which essentially warned of inflation down the road. Meanwhile, real interest rates remained unchanged. Consumer spending didn’t rise significantly until long after the models suggested.
Economic models rely on rational consumer decisions, such as households making big purchases now if they know prices will be higher later. In reality, consumers weigh many factors in timing their purchases, such as changes in jobs and families. They do react as expected when future price increases are more obvious. For example, consumers moved up major purchases when told of a higher sales tax that would take effect in the future, according to a study by Francesco D’Acunto of Boston College, Daniel Hoang of Karlsruhe Institute of Technology, and Chicago Booth’s Michael Weber.
But other research by Weber suggests that many people ignore forward guidance about inflation, or simply are not aware of it, when they make financial decisions. None of the popular economic models can claim accurate forecasts with a population that does not use the information the central bank offers.
Francesco D’Acunto, Daniel Hoang, and Michael Weber, “The Effect of Unconventional Fiscal Policy on Consumption Expenditure,” NBER working paper, August 2016.
———, “Unconventional Fiscal Policy,” American Economic Association Papers and Proceedings, May 2018.
Soon after, Greenspan, the Fed, and other central banks began taking baby steps toward transparency. But it took the 2008–09 financial crisis to really get them talking. Cutting critical short-term interest rates—the banks’ standard response to economic weakness—hadn’t stopped an alarming rise in layoffs, bankruptcies, and market mayhem. The economy needed a lot of spending right away to get businesses thriving and people working again.
To generate this consumption, the Fed promised on December 16, 2008, near the beginning of the financial crisis, to keep interest rates exceptionally low, near zero, “for some time.” The Fed repeated the message throughout the recession, and the ECB put out similar statements. The Fed also named the economic developments, such as employment rates, that would prompt changes to those targets. The specificity of these announcements was historic.
From this forward guidance, the public was supposed to understand that they should buy goods soon, rather than wait. Businesses should hire people, upgrade equipment, and invest in expansion. Consumers should buy cars, refrigerators, furniture, houses, and other big-ticket items.
Theoretically, households that followed the Fed’s lead would benefit financially, as well as advance policy makers’ goals for the broader economy. By making purchases then, while the banks were holding prices down, buyers would pay less than when inflation increased costs later. Spare cash would earn almost nothing socked away in bank accounts, so it would be a good time to invest in just about anything else. The cost of borrowing money could only get higher in the future.
Generally, investors took the hint; households and businesses did not. While the interest-rate promises effectively stabilized financial markets, it was years before businesses hired and consumers spent heavily enough to really help economic growth.
Today’s Fed and ECB leaders strive to make their policy objectives and economic outlooks clear to both investment firms and average citizens. But the research suggests they have yet to put forward guidance into language that motivates the public to act.
Even simplified, interest rates still fail to motivate
Findings by D’Acunto, Hoang, Paloviita, and Weber suggest that only high-IQ individuals follow and react to interest-rate news in the ways that central bankers intend. Their two IQ studies take data from Finland, where homogeneous demographics are useful for disentangling IQ effects from education, income, and other factors. Finland offers citizens free education through university and has one of the highest college graduation rates in the world. Typically, Finnish men take IQ tests with military conscription around the age of 19 or 20, and low- and high-IQ individuals are found across socioeconomic groups. (Finnish women can volunteer for military service but are not conscripted.) The Finnish Defense Forces score the IQ test results on a 9-point standard scale, with a mean score of 5.
The researchers matched the young Finnish men’s IQ scores from 1982 to 2001 to their responses on monthly consumer-confidence surveys conducted on behalf of the European Commission between 2001 and 2015. The surveys solicited household opinions about economic conditions generally and about what prices would do in the future. For example, they asked if it was a good time to make big purchases, such as furniture and electronics.
Interest rates in Finland are ruled by the ECB, and the survey period covered at least two significant policy announcements that the researchers would have expected to guide survey respondents. But only participants scoring between 6 and 9 on the IQ tests—those the researchers classify as high IQ—accurately reported current interest-rate trends and made financial decisions accordingly.
High-IQ men were twice as likely to take advantage of low-interest loans when rates fell. Their likelihood of borrowing remained constant while interest rates were steady, and dropped when interest rates rose. Using annual tax data, the researchers determined that these participants adjusted total outstanding debt balances to match interest-rate changes significantly more often than respondents ranked 5 or lower on the IQ scale.
High-IQ men also said it was a good time to buy big-ticket items when inflation was rising, and a bad time for such purchases when rates were going down.
On the other hand, lower-IQ participants had little knowledge of current or forecasted interest rates. Their plans for spending, saving, and borrowing appeared unrelated to their inflation expectations, which were sometimes wildly inaccurate.
Unlike IQ, income and education did not appear to affect knowledge of interest-rate trends or the propensity to react accordingly.
The researchers considered that lower-IQ men may be less likely to qualify for loans, which might make them unable to borrow more when rates are advantageous. But they find individual leverage ratios—a key debt indicator that lenders consider—to be roughly the same between high- and lower-IQ respondents. They also suggest that lower-IQ men are unlikely to change their consumption plans as inflation expectations change even if they are not financially constrained. If financial constraint had been the meaningful variable, this difference could have explained why changes in inflation expectations did not affect their spending plans.
Avoiding policies for only smart people
Even the most explicit warnings of higher future rates won’t induce spending if people don’t factor inflation into their financial decisions. But most people simply don’t, according to several studies.
Two such studies—the first by University of Notre Dame’s Rüdiger Bachmann and others, the second by the Boston Fed’s Mary A. Burke and Ali K. Ozdagli—find no statistically significant differences in most households’ readiness to buy durable goods, or their actual purchases, on the basis of their inflation expectations. Another study by researchers including Chicago Booth’s Devin G. Pope finds that 20 percent of mortgage holders fail to refinance when rate declines would allow them to save money. (Bachmann notes that studies from Japan and Europe do find a relationship between inflation expectations and economic behavior, making the evidence mixed.)
Should the Fed communicate using rap music?
Central bankers have tried various unconventional tools in their bid to accomplish their monetary-policy goals—and to get consumers and investors to pay attention. Forward guidance (statements intended to manage expectations about potential rate changes) and other strategies have had some success . . . but would they be more effective if the bankers’ words were lyrics backed by a beat?
If the Fed embraced this, it wouldn’t be the first bank to use music to transmit a message. Øystein Olsen, the governor of Norges Bank, Norway’s central bank, in 2017 appeared in a lively cod-themed parody video to promote new banknotes. A few months later, Elvira Nabiullina, governor of the Central Bank of Russia, sang in a video that the Russian bank issued to promote some of its new banknotes.
More recently, the Bank of Jamaica has moved into commissioning new music—it had pop stars record videos to educate the public about topics including the benefits of inflation targeting. Tony Morrison, the bank’s head of communications, told the Wall Street Journal that policies such as inflation targeting “are the type of things that everyone should know about, and the best way to reach the people of Jamaica is through reggae.”
This tactic is a good one, says Chicago Booth’s Michael Weber. “The central bank of Jamaica has been pretty successful in anchoring inflation expectations and reaching the broader population, and I think the Fed and European Central Bank can learn from them,” he says. However, he says that in the United States, monetary-policy plans should be set to rap. If basketball star-cum-rapper LeBron James were to record a song about price stability, he says, the message would reach a wide audience.—Emily Lambert
The work by D’Acunto, Hoang, Paloviita, and Weber sheds light on why the inflation factor tends to get left out of household financial decisions. After establishing that IQ plays a role, they examined what might have made the lower-IQ group less likely to respond as intended.
Although the lower-IQ respondents sometimes lacked or misinterpreted interest-rate information, this was not the key reason for their inaction, the researchers find. Instead, lower-IQ individuals appeared unaware of how to favorably apply the information to their own lives, the researchers argue. As a result, the individuals disappointed central bankers with unresponsiveness even when they accurately interpreted news of the central-bank rate.
To get the public’s attention, central banks may need policies that more obviously affect personal finances. Two studies by D’Acunto, Hoang, and Weber illustrate how Polish and German households significantly increased spending ahead of large, preannounced sales-tax increases. When facing a tax that would make every purchase evidently more expensive, consumers quickly grasped the implications. The forecasted sales-tax increases sparked the sort of consumption rally central bankers hoped interest-rate changes would produce during the global recession.
Short, straightforward announcements about interest rates aimed directly at the public may also help central banks get the responses they want, according to Coibion, Gorodnichenko, and Weber. They find that when consumers read a single sentence stating the Fed’s inflation target, they were more likely to alter their inflation expectations than when they read a news article about the interest-rate change in USA Today.
The researchers note that a continuing disconnect between central banks and lower-IQ households threatens more than effective monetary policy. A consumer-friendly interest-rate policy becomes discriminatory if it enriches only a subset of the population. For judicious and effective monetary policy, central-bank messages cannot be for only the smartest people.
- Rüdiger Bachmann, Tim O. Berg, and Eric R. Sims, “Inflation Expectations and Readiness to Spend: Cross-Sectional Evidence,” American Economic Journal: Economic Policy, February 2015.
- Mary A. Burke and Ali K. Ozdagli, “Household Inflation Expectations and Consumer Spending: Evidence from Panel Data,” Working paper, December 2013.
- Olivier Coibion, Yuriy Gorodnichenko and Michael Weber, “Monetary Policy Communications and Their Effects on Household Inflation Expectations,” NBER working paper, September 2019.
- Francesco D’Acunto, Daniel Hoang, Maritta Paloviita, and Michael Weber, “Human Frictions in the Transmission of Economic Policy,” Working paper, January 2019.
- ———, “IQ, Expectations, and Choice,” Working paper, September 2019.
- ———, “Cognitive Abilities and Inflation Expectations,” American Economic Association Papers and Proceedings, May 2019.
- Francesco D’Acunto, Daniel Hoang, and Michael Weber, “The Effect of Unconventional Fiscal Policy on Consumption Expenditure,” NBER working paper, August 2016.
- ———, “Unconventional Fiscal Policy,” AEA Papers and Proceedings, May 2018.
- Ioana A. Duca, Geoff Kenny, Andreas Reuter, “Inflation Expectations, Consumption and the Lower Bound: Empirical Evidence from a Large Euro Area Survey,” ECB Working Paper 2196, November 2018.
- Hibiki Ichiue and Shusaku Nishiguchi, “Inflation Expectations and Consumer Spending at the Zero Bound: Micro Evidence,” Bank of Japan Working Paper Series 13-E-11, July 2013.
- Benjamin J. Keys, Devin G. Pope, and Jaren C. Pope, “Failure to Refinance,” Journal of Financial Economics, September 2016.
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