Fuqua Insights Podcast: Is the Federal Reserve's Most Powerful Tool Its Words?

Sarah Kern 00:00:03.640 — 00:00:12.960

Welcome to Duke Fuqua Insights, a podcast where we explore faculty research and the actionable takeaways for business leaders at every level.

Uncertainty is a defining factor in economic decision making, showing up in areas like investment decisions and policy sensitive financial conditions. In times of uncertainty, the Federal Reserve's words often matter as much as its actions. Subtle shifts in tone or language can move markets and shape expectations, especially when acting too quickly could be costly.

I'm Sarah Kern, and in today's episode, I'm joined by Professor Anna Cieslak, who studies how central bank decisions and communication shaped financial markets and economic outcomes. Her work shows how policymakers use forward looking signals to influence financial conditions and why markets often react even when policy itself stays the same.

Professor, it's great to have you here today.

Anna Cieslak 00:01:06.970 — 00:01:09.650 

Thank you very much for having me. It's exciting.

Sarah Kern 00:01:09.690 — 00:01:20.690 

When people think about monetary policy, they usually focus on interest rate hikes or cuts. From your perspective, what are we missing when we think about policy only in those terms?

Anna Cieslak 00:01:21.090 — 00:01:21.930 

Great. So, the Fed cares about financial conditions beyond just the short term interest rate. The traditional view has been that the Fed acts on short term interest rates, and that to some extent affects longer term interest rates and broader financial conditions. A more contemporary view, however, including represented by my research, is that the Fed can affect financial conditions even without moving interest rates at all at the short end of the term structure--so the policy rate. This is obviously the case in recent years, when the Fed has increasingly relied on so-called unconventional monetary policy, especially following the global financial crisis. So what I mean, here they have used  forward guidance, large scale asset purchases, when the policy rate itself was at the zero lower bound, and these unconventional tools would affect interest rates and broader financial conditions beyond the very short end of the term structure, obviously, by moving people's expectations of the path of monetary policy, and equally important, their attitudes towards risk. So how willing people are to take on risk, invest in rescue projects, etc. And so here comes the role of communication beyond policy, direct policy actions. Chair Bernanke famously estimated that monetary policy is 98% talk and just 2% action.

So you can imagine how important communication is in the Federal Reserve's toolkit and in what the Fed tries to achieve. And communication is going to be inherently about future. So this is really not news. Even though the Fed has been relying on communication increasingly and has been emphasizing transparency in communication in recent years, communication has been recognized for many years as an important component of the Fed's toolkit. Even under Greenspan, who has been known for mumbling with great coherence, he certainly recognized that sending signals to the public matters in what the Fed tries to achieve. So clearly important and recognized component of policy toolkit.

Sarah Kern 00:03:58.960 — 00:04:17.280 

As someone who studied communication in undergrad, that's music to my ears. All right. Switching gears a little. Your research introduces the idea of a policy tilt. What does that mean in practice? And how is it different from things like forward guidance that people may already be familiar with?

Anna Cieslak 00:04:18.040 — 00:05:37.170 

Great. So that's a great question. Indeed, we have studied extensively and thought a lot about policy tilts in addition to action. So policy tilt is going to be something that they communicate with words through their language, and it is signaling of their future policy intentions. That is what is the likely path of a policy rate under certain scenarios.

So policy tilt serves to reveal any asymmetries or biases in future policies as envisioned by policymakers today. Forward guidance is one example that has become really prominent following the global financial crisis, and the Fed has relied obviously on forward guidance. I would say that the tilting is a broader concept, and forward guidance is a subcategory that is more committal than just sending some general signals.

So it could view signaling by the Fed as having different levels of commitment. Policy tilts are a broader concept than just doing forward guidance, which has very specific horizons as to and preferences about the path of the policy. So, you can think about the tilt as reflecting what the Fed is perceiving in terms of risks to its dual mandate. They are not acting on those risks today yet, but they signal that they are vigilant about those risks and they will be ready. They are ready to act, should the need arise. So, tilting monetary policy is --signaling those tilts--is broader than just signaling what the Fed thinks about in terms of their expectations of economic conditions. It is signaling the risk perceptions that they have to its dual mandate.

Sarah Kern  00:06:30.130 — 00:06:36.770 

So would a policy tilt include forward guidance, or are they two separate things?

Anna Cieslak  00:06:36.810 — 00:07:06.180 

No, you could think about forward guidance as a specific type of a policy tilt, which is more committal in a sense. The Fed is, I would say, in terms of strength, this is one of the stronger communication or signaling tools that the Fed has been using, but it's a way to signal a tilt in policy with relatively strong degree of commitment.

Sarah Kern  00:07:06.300 — 00:07:16.340 

Why does the Fed put so much weight on low probability but high-cost risks, instead of just responding to its most likely economic forecast? 

Anna Cieslak 00:07:16.380 — 00:09:40.560 

So, this is the part of the broader approach to monetary policymaking that the Fed has been pursuing since at least early 90s, certainly starting in the 90s under Greenspan. And the idea is something that people called risk management approach to policymaking. So what is risk management? Greenspan has described that beautifully as emphasizing and understanding as much as possible the many sources of risk and uncertainty that policymakers face, quantifying those risks when possible, and assessing the costs associated with each of those risks.

So essentially, the Fed is thinking what could go wrong? Where could I be wrong in terms of my point forecast of where the economy is heading? And they draw different scenarios, attach probabilities to those scenarios. Some of these scenarios are going to be very costly for them. And they may want to take preemptive action, take out so-called insurance against those costly undesirable scenarios. These are tail events. But once you are, once the tail realizes, it becomes very costly for policymakers to unwind that effect, so they may take preemptive action, take out insurance to prevent ending up in there. And that's what is called, you know, the risk management approach to policymaking, something that we've been studying.

Now, this ties back to communication because communicating that ability to act should an undesirable scenario realize also leads to people updating their beliefs about what the Fed is going to do, and may reduce risks that the public perceives in the overall economy. So essentially, communication is a component of the risk management approach where the Fed is communicating their awareness of risks and signals that they will not be caught off guard should those risks become more prominent.

Sarah Kern 00:09:40.600 — 00:09:55.330 

That makes sense. The Fed often talks about being data dependent, but the data is rarely clear cut. How do concerns about acting too early or too late show up in the way policymakers communicate, even when they don't take action?

Anna Cieslak  00:09:55.370 — 00:11:13.580 

So that goes back to the point about risk management. So they want to signal they are readiness to act if needed and they are vigilant. So what in particular are they concerned about? They are concerned about broadly two things. One is this anchoring of inflation expectations, especially to the upside where you get into this loop of self-fulfilling inflation expectations, very undesirable for the Fed, very costly in terms of their credibility.

The other one is this anchoring of, or essentially hitting the zero lower bound, which means you are facing a weakening economy, you go down to the nominal interest rate at zero and now you're stuck. You cannot do more with the nominal interest rate. So they want to prevent those scenarios and to prevent them, they are worried that they may be too late, in order to be able to effectively address those risks. And so they are willing to take out insurance to prevent these kinds of undesirable scenarios to be coming likely.

Sarah Kern  00:11:13.620 — 00:11:19.100 

So it goes back to risk management being a communication tool of sorts.

Anna Cieslak  00:11:19.140 — 00:11:50.950 

Part of the risk management approach is certainly communication. And it would be communication through the tilts. So the Fed can manage risks both through taking preemptive actions, that they say easing earlier or easing more aggressively. But the other way that they can take out insurance is by communicating the tilt, communicating the readiness to act.

So both components play a role.

Sarah Kern  00:11:50.990 — 00:12:02.950 

One of your key findings is that the Fed's words alone can move financial markets. How does communication end up affecting things like long term interest rates or overall financial conditions.

Anna Cieslak  00:12:02.990 — 00:13:40.810 

Great. So you can think about three broad channels. And I think this is a really important question. We are still working on figuring it out. But I guess we have now a good sense of what these channels are and probably also of their relative importance. So the first channel is that the Fed would be moving expectations of future policy, and that will translate into longer term interest rate. The second channel, which I believe is very powerful, is the Fed affecting risk premia in financial markets. So you could think about either the amount of uncertainty, amount of risk, or the price of risk that investors perceive and require. The third channel is that the Fed could also reveal some information about the state of the economy in the longer run, in more distant future that the public didn't have.

And that one is probably more controversial because the Fed themselves admit they don't have significant information advantage about what is going to happen in the long run compared to the public. So my research focuses a lot on thinking about how, through which mechanisms does the Fed affect risk perceptions and the risk premium in financial markets, and they will play a significant role for long term interest rates and for broader financial conditions.

Sarah Kern  00:13:40.850 — 00:13:48.730 

It's almost like their influence is just as important, if not more important, than access to unique data sets.

Anna Cieslak  00:13:48.770 — 00:14:19.930 

Sure. Yes, I would broadly, broadly agree with that. Although the Fed is data driven, so communication is never in a vacuum. Communication will be driven by what they perceive the risks to their dual mandate be. And so there needs to be a level of consistency, significant consistency for the sake of Fed's credibility between the data that they have and the signals that they are sending.

Sarah Kern  00:14:20.010 — 00:14:29.890 

You find that signaling a tightening tilt can actually make markets calmer. Why can sounding tougher sometimes ease financial conditions rather than tighten them?

Anna Cieslak  00:14:29.890 — 00:17:10.000 

So, that may initially sound counterintuitive. We show that the effect runs through term premia, through risk premia in long term treasury bonds. And suppose that the market is concerned about the Fed's reaction to inflation, let's say, okay, thinking that maybe the Fed is too easy on inflation. What this would mean is that the market, because of that concern, because of some disagreement between the Fed and the market on what the optimal policy response should be, markets will be pricing the risks of the Fed essentially making a policy mistake, and that effect will drive up risk premium. Now what the Fed can do again through signaling they are tilt: they can assuage market concerns that the Fed is actually acting inadequately to what economic conditions would suggest.

So we have found this to be a rather powerful effect. And here is, though, an important caveat in understanding this effect. Sounding tougher, it's not unconditional toughness. It is signaling again that the Fed is ready to tighten should the need arise to do so. So it's conditional statements to signal the vigilance that we talked about before.

And one fantastic example of this is actually late '90s going back to what is called Greenspan's productivity miracle. In that period, the economy was booming and people were expecting there will be a lot of inflation. Greenspan had a different view. He thought that the productive capacity of the economy has increased and therefore tightening would not be the right policy move.

At the same time, however, while he was, he decided not to change current policy, right, he was communicating to the public that he is ready to act, should the need arise. And what we saw in this period is a downward trend in risk premia, in treasury term premia, against the backdrop of a booming economy, which in my research, I have causally linked to the Fed's communication of that policy--tighter policy tilt if needed.

Sarah Kern  00:17:10.000 — 00:17:12.199 

Because people like to feel secure.

Anna Cieslak  00:17:12.240 — 00:17:20.439 

They want to know that on the other side, there is somebody who sees the risks and can do something about them.

Sarah Kern  00:17:20.439 — 00:17:32.360 

Right, already has a plan in mind. Your paper also shows that communication doesn't always work as intended. Based on recent experience, what are the limits of using words as a policy tool?

Anna Cieslak  00:17:32.720 — 00:20:23.630

That's actually a great question, and it's very relevant for some of the events of the more recent past, post Covid. So I told you about the quote from Bernanke that monetary policy is 98% talk and only 2% action. That's what is quoted a lot. But there is another part of that quote. He also said that the cost of sending the wrong message can be very high, ok? Sometimes communication doesn't work as intended. And post-Covid we saw an example of that. This was a period in which the Fed was communicating, especially in 202, early 2021--so we are already deep into Covid pandemic. The economy starts to sort of recover, but the Fed is communicating lower for longer.

They are very credible in communicating, and they are credible in making people believe they would not move interest rates. At the same time, there is massive fiscal spending, massive stimulus. So concerns about inflation are starting to emerge. But the Fed is steadfast in lower for longer. And this is a period when Fed's communication starts to diverge from what the market concern was.

What we observe in this period, consistent with some of the stories that I told you, is that uncertainty about the Fed's reaction function leads to increases in term premia. So even though the Fed wants to maintain easy condition, it's credible for not moving short term interest rates for an extended time, financial markets are starting to price risks and financial conditions nevertheless tighten, despite those lower for longer statements and perhaps because of them. And so the term premium starts to rise and long-term interest rates start to increase in 2021. This is one example of, I would say, a communication mistake or a policy mistake, that was however short lived, relatively short lived as the Fed pivoted in their first, in their language, in their communication, and later in their policy actions, we see that this had very significant effect on stabilizing term premia, and in fact, it helped unwind some of the tightening of financial conditions that was occurring because of negative incoming macroeconomic news.

Sarah Kern 00:20:23.630 — 00:20:33.750 

For business leaders or investors navigating uncertainty today, how should they listen to the Fed to get its message, beyond focusing on whether rates will move at the next meeting?

Anna Cieslak  00:20:33.790 — 00:21:51.800 

So I think it is important to recognize just that, just like the business leaders, the Fed also faces similar uncertainty. And they make decisions not knowing actually the exact state of the economy today. They don't know exactly what forces are shaping the outcomes that they care about. And so of course, they know even less about which scenarios that they portray are going to materialize in the future.

And so I think what is really important is to understand how the Fed thinks about the balance of risks, listen what they are saying about their balance of risk assessments and then understanding how their risk management motives are going to affect their policy choices. Additionally, we talked a lot about communication.

And so communication is clearly a powerful tool in conveying facts risk assessments. But to some degree it is chair specific. Perhaps to a large degree it is chair specific. So it will be actually very interesting to see what is the new approach to communicating those risks that the new chair adopts.

Sarah Kern  00:21:51.840 — 00:21:53.240 

Totally. Thank you.

Anna Cieslak  00:21:53.280 — 00:21:56.800 

Thank you. Very interesting. Thank you for great questions.

Sarah Kern  00:21:57.000 — 00:21:57.920 

You're welcome.

Duke Fuqua Insights is produced by the Fuqua School of Business at Duke University. You can learn more at Fuqua.duke.edu/podcast