How Do Higher Interest Rates Bring Down Inflation?

How Do Higher Interest Rates Bring Down Inflation?

This kind 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 for his second term as the leader of the Fed on Thursday, has made it central. The Fed uses official statements, publicly disseminated economic projections, speeches, interviews and news conferences to tell the markets where it wants them to be heading.

At this moment, Professor Phelps said, the Fed may be “scaring people in financial markets into believing that they should lower their expectations of inflation.”

He added, “The Fed is saying we should believe the inflation rate is going to fall as a result of the Fed’s efforts.” The idea is that “the markets are already expecting that the Fed is going to succeed in lowering expectations of inflation, and that will lower inflation itself.”

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

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

That, in my view, is a major reason for the heightened anxiety and volatility in the markets. There is no stable consensus on where the Fed is going or whether it can get there.

Professor Phelps is skeptical, too. “I have no idea how much importance to attach to that thinking, that forward guidance,” he said. “Lots of people will have their own thoughts about future Fed policy and I’m not sure that their expectations can be directly manipulated in this way, but it’s an interesting question. Really, I don’t know to what extent central banks are effective in altering expectations of inflation, of guiding people to a particular rate of inflation.”

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