Great Fed Expectations

What people expect the U.S. central bank will do might be just as important as what it actually does.

Federal Reserve Chairwoman Janet Yellen's speeches are widely covered and intensely scrutinized for what the Fed might do. (Brian Snyder / Reuters)

Speculating about the possible actions of the U.S.’s central bank is a cherished American pastime. Last summer, ahead of the Fed’s September meeting, observers wondered if the Fed would raise interest rates for the first time in nearly a decade. Analysts and journalists referred to the excitement as a “cliffhanger”; they said that the Fed had set the stage for some “high drama,” and hyped it as the “most important, and possibly most difficult” and most anticipated Fed meeting of the year. It was the decision we’d been “all patiently awaiting”: the “big one.”

Perhaps these hyperboles were warranted, given that low interest rates have been part of the Fed’s monetary policy since 2007, when they were put in place for a post-recession recovery effort. But there’s a reason so many people closely follow the Federal Open Market Committee’s eight annual closed-door meetings. It’s during these meetings that the U.S.’s central bank debates and enacts important monetary policies, which change the cost and availability of money—something that affects anyone who is a participant in the U.S. economy. For that reason, there’s so much interest in what the Fed will do that economists are constantly surveyed about it. And further, whether the Fed leaves rates as they are or raises them, the decision is newsworthy all the same.

Interest rates were set near zero for years after the Great Recession, and any rumblings that the Fed might raise interest rates for the first time in nearly a decade caused a lot of commotion. And finally, the Fed did raise rates last December, but weak global economic growth and signs that the U.S. economy is slowing have delayed further rate hikes this year. The June Fed meeting kicks off today. As usual, many economists and financial analysts will be paying close attention to the minutes following the U.S. central bank’s meeting—though at this point, it’s widely expected that, because of recent tepid U.S. economic indicators, the Fed will not raise interest rates at this particular meeting.

But as it turns out, these expectations are pretty important too, especially when interest rates are so low. According to a Dallas Fed working paper by Rachel Doehr and Enrique Martínez‐García, a visiting scholar and an economist at the Dallas Fed respectively, public expectations about monetary policy can be responsible for economic activity in and of themselves. Using historical survey data from the Philadelphia Fed and The Wall Street Journal to augment traditional economic models, they found that expectations about interest rates are not only quantitatively important in driving economic activity, but that this effect is quite different when rates are near zero.

“Our research shows that such a downward revision of rate expectations, when at or near the zero-lower bound, as we are now, in and of itself actually catalyzes employment growth. So in the short term, the market reaction to the May jobs report … actually stimulates job growth and a decrease in unemployment, independent of action taken, or not taken, by the Fed,” says Doehr. This is in line with the assumption that households and firms want to avoid shocks to their budget, so expecting that interest rates will fall (or rise) makes them more likely to spending more (or less) now. Away from the zero bound, however, the results were the opposite: A rise in interest-rate expectations led to a decrease in the unemployment rate—as the Fed is able to “do something” away from the zero bound and react to these expectations.

In terms of a longer-term perspective, this research highlights something most Fed watchers already knew—that it’s really really important that the Fed communicates clearly in order to avoid big surprises when it comes changes in interest-rate expectations. Managing expectations then, might be yet another policy tool for the Fed to prepare markets for rate hikes or holds. Particularly in this time of transition, when rates are rising after being so close to zero for so long, communicating and preventing expectation shocks will smooth the process. But there’s reason for the Fed’s silence too: Many suspect it to be a calculated move meant to give the committee more flexibility in its decision making.