Key Takeaways

  • In May 2021, the US economy suffered an annualized inflation surprise of 6%, yet two-year Treasury yields did not move at all.
  • Forecasters across Wall Street expected zero policy rates throughout 2021, regardless of their individual inflation forecasts.
  • The market-perceived reaction coefficient on inflation stayed flat at zero until the Federal Reserve began actual rate hikes in 2022.
  • Investors only shifted their perceived reaction coefficient from zero to one between early 2022 and late 2023, proving that words failed to move expectations.

The Breakdown of Verbal Forward Guidance

In May 2021, the United States recorded an inflation print that caught forecasters off guard. The monthly surprise alone was nearly 0.5%, translating to an annualized surprise component of 6%. In a normal bond market, front-end yields would spike immediately to price in central bank tightening. Instead, the two-year Treasury yield stayed flat.

Carolin Pflueger, a finance professor at the University of Chicago Harris School of Public Policy, tracked forecaster expectations during this window. Central bank guidance had convinced the entire market that rates would remain glued to the floor.

“And the perceived reaction function that we saw at that time was extremely flat,” Pflueger notes. “So there was a perception that the policy rate would stay at zero pretty much irrespective of economic conditions.”

The Fed had adopted average inflation targeting and leaned heavily on verbal communication. Markets took that guidance literally. Pflueger found that even forecasters who correctly predicted higher inflation still expected the Fed to keep the policy rate at zero. The central bank promised patience, and the market treated that promise as a permanent commitment.

The Learning From Actions Channel

Words alone could not convince markets that the Fed would fight inflation. Market participants only revised their models when the Fed began raising rates in early 2022.

Pflueger describes this shift as the learning from actions channel. Economic agents do not update their beliefs about policy rules from press conferences and speeches. They update their beliefs when they see actual balance sheet and interest rate moves.

“So after the Fed started to act, that's when, in our data, we see that the perceived inflation response really picks up,” Pflueger explains. “It basically goes from zero to one between, say, early 2022 towards the end of 2023.”

This delay created massive policy lags. Because the market assumed zero response for over a year, financial conditions stayed loose long after price pressures emerged. Central bankers thought they were guiding expectations smoothly. In reality, they created an abrupt adjustment period once rate hikes finally started.

Credibility Is Built on Execution

The gap between what leaders say and what observers believe is not unique to monetary policy. When you tell your team or your investors that priorities have changed, they will look at your calendar, your budget, and your hiring decisions instead of your announcements. If you claim a project is urgent but allocate zero capital to it, people assume the true priority is zero.

The Fed spent two years talking about flexibility, but market behavior only shifted when the benchmark rate started climbing 75 basis points per meeting. Observers do not learn from your stated strategy; they learn from your actual resource allocation.

What to Do With This

Audit your company's stated strategic priorities against your last three budget approvals and executive hires. If you announced a new core objective this quarter but shifted zero headcount or capital toward it, cancel the next town hall announcement and reallocate the budget first.