MNI: Fed's Strong Inflation Reaction Boosted Credibility-Paper

The Federal Reserve's aggressive response to the post-covid surge in inflation helped reinforce public and market expectations that it would not let price pressures get out of control, likely reducing the economic toll of monetary tightening, according to a new paper presented at the Kansas City Fed Jackson Hole conference Saturday.

“Episodes of high inflation reveal whether a central bank is indeed committed to fighting inflation, and whether this commitment is perceived as credible,” wrote Michael Bauer, a senior research advisor at the San Francisco Fed, and co-authors.

“The significant increase in the Fed’s perceived responsiveness to high inflation confirms that this is indeed the case: Monetary policy perceptions are consistent with the Fed’s strong commitment to price stability.”

The Fed raised interest rates sharply, by 500 basis points in just over a year starting in March of 2023, and has kept the fed funds rate at a 23-year high of 5.25%-5.5% since July of last year. Yet the economy and employment have remained stable and robust, defying expectations for recession.

The authors of the paper, entitled “Changing Perceptions and Post-Pandemic Monetary Policy,” argue this is due in part to the beneficial communications effect of the Fed’s perceived ability to rise the inflationary challenge.

“The increase in the perceived inflation response likely aided the transmission of monetary policy to the real economy and improved the Fed’s inflation-unemployment tradeoff.”

Another sign that the Fed boosted confidence in its reaction function was increased bond market sensitivity to inflation data surprises, the authors said.

“Consistent with a shift in the perceived policy response, event studies show that interest rates became significantly more sensitive to inflation data surprises following liftoff,” they wrote.