The Fed as social psychologist

By Scott Sumner.

"During 2020, public health authorities occasionally put out false or misleading information, or delayed useful innovations, based on armchair theories about how the public reacts to risk and uncertainty. I recall pundits like Alex Tabarrok and Tyler Cowen pointing out that public health authorities are generally not experts on social psychology, and thus should not try to micromanage the public’s mood.

A similar problem can occur with monetary policy. A new paper by Michael Bauer and Eric Swanson cites a recent example:

For example, in the minutes of the FOMC meeting on March 15, 2020, participants were concerned that a strong monetary easing surprise “ran the risk of sending an overly negative signal about the economic outlook.”  [p. 55, footnote]

I’ve spent much of my life studying market reactions to monetary policy news, and have the strong impression that the markets are much more worried about what the Fed doesn’t know than what it does know. Both the Fed and the markets have pretty similar information regarding macroeconomic aggregates and asset market price movements. The biggest problems arise when the Fed has the wrong model, and makes a decision that market participants view as likely to lead to a negative outcome for the economy. Lots of these bad decisions occurred in the early 1930s, and again in late 2008. The fear isn’t that a rate cut will expose an already weak economy, it’s that the Fed won’t cut rates when it’s clear to market participants that a rate cut is appropriate.

The preceding is based on my reading of monetary history, not a rigorous study of the data. But Bauer and Swanson have done such a study and also conclude that the Fed should simply do the right thing, and not second guess how markets will react to their moves:

Our results also have important implications for central bank communication and the conduct of monetary policy. First, along with Bauer and Swanson (2021), we find little or no evidence that FOMC announcements have a substantial “Fed information effect” component. Although the minutes of recent FOMC meetings reveal that some participants worried about the potential for counterproductive information effects, our results indicate that policymakers have little need to fear that information effects might attenuate the effects of their announcements, except possibly in exceptional circumstances (which our results cannot rule out).  [p. 55]

The Fed should focus on doing the right thing, and not try to second guess how the market will interpret sound monetary policy."