Does Personal Experience Affect Monetary Policy Decisions?

Will the central bank in the United States reduce or maintain the current interest rate? Do statements made by the Board Chair suggest a possible increase in the interest rate? What is the central bank´s forecast for inflation and employment in the medium-term? Every day, international financial markets are highly attentive to the monetary policy decisions of central banks, the restrictive or accommodating tone of their meetings, and the statements made by members of their Boards. Central bankers whose main objective is to maintain low inflation through higher interest rates and more restrictive monetary policies are known as hawks, while those that give priority to other factors, such as unemployment, are known as doves. Both stances greatly affect the policy decisions made by central bankers.

Ulrike Malmendier, Stefan Nagel and Zhen Yan recently explored the formation of these outlooks in their paper, “The Making of Hawks and Doves: Inflation Experiences on the FOMC”. Among members of the Federal Open Market Committee (FOMC) of the Federal Reserve (FED), the authors found that personal life experiences influenced voting decisions, decisions regarding the federal funds rate, inflation forecasts, and the tone of member speeches. In particular, different lifetime experiences of inflation produced divergence in monetary policy decisions and macroeconomic outlooks, which helped to predict the magnitude of hawkish and dovish biases among members.

In their research, the authors considered voting members from March 1951 to January 2014. They constructed experienced-based inflation forecasts by applying an adaptive learning rule used by Malmendier and Nagel in 2016. According to this model, members use their personal inflation experience–formed by inflation data realized over the course of their lifetimes–in order to estimate the long-term average and persistence of inflation.

The results showed a strong association between inflation experiences and voting behavior among members. An increase of one standard deviation in the experience-based inflation forecast was associated with an increase in the probability of a hawkish outlook, as well as a decrease in the probability of a dovish outlook, both by one third. Furthermore, the authors find that when a FOMC member had a higher experience-based inflation forecast, their speeches also reflected an increasingly hawkish tone.

Likewise, the authors find that the federal funds rate target is inclined toward the average of the experience-based inflation forecasts of the members rather than the projections of inflation published by the Federal Reserve. Moreover, results suggest that in the 1980s and 1990s, the FED´s inflation forecasts were very similar to the average experience-based forecasts of FOMC members. In the 2000s, however, the staff inflation forecast was between 0.5 percent to 1 percent lower than the rate that was actually chosen. In this context, the authors find that their experience-based inflation forecast helps to explain the difference in members’ inflation forecasts; FOMC members put a weight of approximately 37 percent on their experience-based forecasts and 63 percent on staff forecasts.

This paper presents great empirical value as it is the first to provide evidence of the impact of personal experience on the decisions and expectations of central bankers. Similarly, it can help in understanding the potential effect of new FED appointments on future policy decisions. Given the relevant and long-lasting effects of life experience on macroeconomic policy, central banks should take them into account when choosing new members in order to avoid biases and achieve a balanced committee. Further research should assess the applicability of this model to other policy areas which may help to improve predictions of policymakers’ behavior.

Article source: Malmendier, Ulrike, Stefan Nagel and Zhen Yan. “The Making of Hawks and Doves: Inflation Experiences on the FOMC.” National Bureau of Economic Research, Working Paper No. 23228 (March 2017).

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