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How do higher interest rates lower inflation?


This type of communication was less common 30 years ago. But a series of Fed chairs – Alan Greenspan, Ben S. Bernanke and Janet L. Yellen – expanded the practice. Jerome H. Powell, confirmed Thursday for his second term as head of the Fed, succeeded central. The Fed uses official statements, publicly released economic projections, speeches, interviews and press conferences to tell markets where it wants them to go.

Right now, Prof Phelps said, the Fed could be “scaring people in financial markets into thinking they should lower their inflation expectations”.

He added, “The Fed is saying we should believe the inflation rate will come down because of the Fed’s efforts.” The idea is that “markets already expect the Fed to succeed in lowering inflation expectations, and that will lower inflation itself.”

That’s the theory, at least. There is evidence that it works. Longer-term interest rates have risen significantly this year, not just in mechanical response to increases in the fed funds rate, but as a reflection of changing views in the markets as to where the Fed wants interest rates and inflation to be a year or two from now.

This approach, however, has a drawback. It’s like the old telephone game. Start by whispering “higher interest rates and a soft landing for the economy” and before you know it, that message, passed from person to person, has become totally different. Fed messages mean different things to different people. Some people hear “recession”.

This, in my opinion, is a major reason for the increased market anxiety and volatility. There is no stable consensus on where the Fed is headed or whether it can get there.

Professor Phelps is also skeptical. “I have no idea how much importance should be attached to this thinking, this forward-looking direction,” he said. “A lot of people will have their own opinion on future Fed policy and I’m not sure their expectations can be directly manipulated in this way, but it’s an interesting question. Really, I don’t know how effective central banks are at changing inflation expectations, at guiding people to a particular rate of inflation.

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