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.