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We combine questions from the Michigan Survey about future inflation, unemployment, and interest rates to investigate whether households are aware of the basic features of U.S. monetary policy. Our findings provide evidence that some households form their expectations in a way that is consistent with a Taylor (1993)-type rule. We also document a large degree of variation in the pattern of responses over the business cycle. In particular, the negative relationship between unemployment and interest rates that is apparent in the data only shows up in households׳ answers during periods of labor market weakness.

“Improving the public׳s understanding of the central bank׳s policy strategy reduces economic and financial uncertainty and helps households and firms make more-informed decisions. Moreover, clarity about goals and strategies can help anchor the public׳s longer-term inflation expectations more firmly and thereby bolsters the central bank׳s ability to respond forcefully to adverse shocks.” (Bernanke, 2010). Central bankers often emphasize the need to communicate with the public to improve its understanding of monetary policy. As the argument goes, this should allow households and firms to make better-informed price- and wage-setting decisions, and improve policy effectiveness. More generally, agents׳ understanding of how policies that affect their decisions are conducted is perceived to be a key ingredient in the policy transmission mechanism. This perception is guided by economic theories in which the behavior of the economy depends on the interaction between the actual conduct of policy and agents׳ understanding of it.1 In this paper we take a step back from the literature on central bank communication, expectations formation, and monetary policy effectiveness, and try to answer the more basic question of whether economic agents – U.S. households in particular – understand how the Fed conducts monetary policy. Since the work of Taylor (1993), it became standard practice to posit that the Fed sets interest rates according to a “Taylor rule” that specifies a target for the policy rate as a function of deviations of inflation from its objective and some measure of slack in economic activity, such as the output gap. Our goal is to assess whether U.S. households are aware of what we refer to as the basic principles underlying the Taylor rule: that the policy interest rate tends to increase with inflation and to decrease with slack in economic activity. Most of the time, these principles provide a qualitative description of how the Fed pursues its so-called dual mandate of price stability and full employment. While there is a large empirical literature on estimation of central banks׳ interest rate policy functions,2 there is much less empirical work on the question of whether households understand monetary policy. One may wonder why this is the case. A possible answer is that this question is not important. In a world with complete asset markets, it arguably suffices that agents who participate in financial markets understand monetary policy. If so, asset prices will correctly reflect current and future policy developments, and those who do not understand monetary policy can simply rely on asset prices to make fully informed consumption and investment decisions. Under incomplete markets, however, households׳ expectations about future monetary policy may affect their behavior. An extreme case is that of an economy with only a one-period nominal bond. In that case, the short-term nominal bond price only reveals the current interest rate, and thus its price is not informative of financial market participants׳ views about future monetary policy. Hence, households׳ intertemporal decisions will hinge on individual beliefs about the future course of the economy – and of monetary policy in particular.3 Beyond these theoretical considerations, the effort that the Federal Reserve devotes to educating the general public and communicating about monetary policy suggests that the question posed in this paper is important for policymaking.4 So, perhaps the lack of empirical work in this area simply reflects the fact that households׳ perceptions about monetary policy are not directly observed nor surveyed. This paper addresses the question of interest by combining households׳ answers to survey questions about future inflation, unemployment, and interest rates from the Survey of Consumers (Michigan Survey). At an intuitive level, our simple empirical approach is based on the idea of separating survey answers about interest rates, inflation, and unemployment that are consistent with the basic principles underlying the Taylor rule from those that are not. To fix ideas, suppose that the Fed׳s target for the federal funds rate depends positively on contemporaneous inflation and negatively on contemporaneous unemployment, and changes only with these two variables. Then, to be consistent with the aforementioned principles, survey answers that indicate unemployment will go down and inflation will go up in one year would necessarily have to be accompanied by an answer that the Fed will tighten monetary policy over the same period. Likewise, answers that unemployment will go up and inflation will drop must be associated with a call that the Fed will ease policy.5 More generally, however, an answer that is inconsistent with a particular version of the Taylor rule need not imply a misunderstanding of monetary policy. The reason is that no specific interest rate rule is a perfect description of policy. To address this issue and provide an answer to our research question that can be relied on more generally, we look for consistency in households׳ answers by testing whether various empirical frequencies of households׳ responses about future interest rates, inflation, and unemployment differ from each other in a way that is consistent with the basic principles underlying the Taylor rule. To give a concrete example, given a response about future unemployment, our empirical approach is to test if forecasts that interest rates will go up are more prevalent among households that predict higher inflation than among those that predict lower inflation. Despite important limitations, the Michigan Survey data turn out to be informative of the question posed in this paper. Our results are broadly consistent with the view that (at least some) U.S. households are aware of the basic principles underlying the Taylor rule when forming their expectations about interest rates, inflation, and unemployment. The extent to which this happens, however, is not uniform across income and education levels. Moreover, there are important differences in the patterns of responses over the business cycle. Specifically, households׳ answers are more consistent with a Taylor rule during times of labor market weakness. Our findings survive an extensive battery of robustness checks. While our tests are based on a reduced-form empirical approach, the relationships uncovered between households׳ answers about inflation and unemployment on one side and interest rates on the other side can be given a causal interpretation. This requires addressing the possible problems posed by endogeneity and reverse causality. We do so by resorting to a dynamic, stochastic, general-equilibrium (DSGE) model as a laboratory. Using the model, we study how the relationships elicited with our approach are affected by general equilibrium effects of autonomous changes in interest rates on inflation and unemployment. The results show that the correct signs of the relationships of interest can be uncovered, despite the presence of those general equilibrium effects. The paper also provides additional empirical evidence that our tests are indeed informative of households׳ perceptions of monetary policy and not of the so-called Fisher equation – a positive relationship between nominal interest rates and expected inflation. This is done by exploiting time periods in the mid-2000s during which Fed policy arguably deviated from a Taylor rule. The pattern of households׳ responses during those periods changed accordingly. As an additional step to interpret our results for the Michigan Survey, the same empirical approach is applied to forecasts from the Survey of Professional Forecasters (SPF). Professional forecasters are arguably more likely to be aware of how monetary policy is conducted. Despite some challenges associated with sample size, our findings support the view that professional forecasters׳ answers to the survey are consistent with the basic principles underlying the Taylor rule in both its unemployment and (core) inflation dimensions. A few recent papers investigate whether professional economists׳ and financial market participants׳ forecasts of interest rates, inflation, and output growth or some other measure of economic activity conform with Taylor-type interest rate rules. Mitchell and Pearce (2009) analyze the Wall Street Journal׳s semiannual survey of professional economists, Carvalho and Minella (2009) study the Focus Survey of market participants conducted by the Central Bank of Brazil, and Fendel et al. (2011) rely on the Consensus Economic Forecast poll for the G-7 countries. These three papers estimate Taylor rules by panel regressions using numerical forecasts and address quantitative questions, such as whether the estimated coefficient on inflation is greater than unity. Schmidt and Nautz (2010) also use forecasts from financial market experts, but their panel data from the ZEW Financial Market Survey are categorical in nature – the expected direction of changes in interest rates, inflation, and the economic situation in the euro zone. They focus on the accuracy of interest rate forecasts and on decomposing forecast errors into those for inflation and economic activity and those due to misunderstanding of how the European Central Bank conducts monetary policy. These four papers are thus related to our analysis of the SPF. However, our empirical approach differs from theirs, since it is tailored to our analyses of the Michigan Survey. Finally, Hamilton et al. (2011) use the effects of macroeconomic news on fed funds futures contracts to estimate the market-perceived Taylor rule. More broadly, our paper is related to the literature that uses survey (or experimental) data to study whether agents form expectations in ways that are consistent with economic theories (e.g., Armantier et al., 2011, Andrade and Le Bihan, 2013, Bachman et al., 2012, Coibion and Gorodnichenko, 2010, Madeira and Zafar, 2012 and Malmendier and Nagel, 2013), and to the literature on financial literacy (e.g., Lusardi and Mitchell, 2011, references therein). More recently, Dräger et al. (2013) extend our approach to study other macroeconomic relationships. Section 2 starts by describing the data used in our analyses, and introducing our empirical approach. Section 3 reports our empirical findings. Section 4 provides a discussion of our results, addressing issues such as endogeneity and causality. It also discusses possible interpretations of our results. The last section concludes. The online appendix provides additional analyses and results that confirm the robustness of our findings.

We combine questions from the Michigan Survey about inflation, interest rates, and unemployment to investigate whether U.S. households are aware of how monetary policy is conducted in the United States. Our estimates of the partial effects of inflation and unemployment are broadly consistent with the view that at least a fraction of U.S. households have in mind some sort of a Taylor rule when forming their expectations about those variables – some differences across demographic groups notwithstanding. In addition, the partial effects of unemployment reveal a large degree of business cycle variation, which seems to be associated with labor market conditions. Does this mean that households understand the basic features of U.S. monetary policy? If so, how should one interpret the important degree of business cycle variation in the pattern of household responses? Of course one possible answer to the first question is that they do not. But then, how to make sense of the estimated partial effects of inflation and unemployment and their statistical significance, the degree of business cycle variation in the estimated partial effects of unemployment, the change in the partial effects of inflation precisely during the Taylor deviation and Fed deviation periods, and the differences in results in the pre- and post-1987 samples? These findings warrant an explanation. Maybe households are “empiricists” and simply repeat patterns they observe in their own experiences.28 In that case they might end up responding as if they understand monetary policy. The other possibility is that at least some groups of households do understand monetary policy. But then we are left to explain the business cycle variation in the partial effects of unemployment. There are two possible explanations. The first one is that households are perfectly attentive to macroeconomic developments and monetary policy, and the relationship between inflation, unemployment, and interest rates implied by Fed policy indeed varies systematically with the state of the labor market. To the best of our knowledge, this possibility has not yet been investigated in the empirical literature on Taylor rules. Alternatively, households may be inattentive and only think about monetary policy at times when doing so may be worth its while, or at times when monetary policy is relatively more salient. These might be times in which the labor market is weak, and unemployment makes the headlines.29 To investigate this possibility rigorously, one would need to analyze periods in which unemployment is not particularly high, but nevertheless people might be paying attention to the state of the economy for exogenous reasons. Regardless of the driver of business cycle variation in the pattern of responses, we can conclude that households׳ beliefs about the evolution of inflation, unemployment, and interest rates – as elicited by the Michigan Survey – are related as if they had some understanding of U.S. monetary policy – particularly the more educated (and higher income) households. The natural next step is to investigate whether households act on those beliefs. If so, they behave as if monetary policy affected their decisions. Recent research has tried to answer related questions that may help us complete this puzzle. Bachman et al. (2012) investigate whether households׳ “readiness to spend” – as measured by the responses to the Michigan Survey questions about buying intentions – is related to inflation expectations. They find that it is not, but provide evidence that buying intentions are correlated with expectations about the evolution of borrowing rates. Armantier et al. (2011) study the relationship between reported inflation expectations and investment decisions in a financially incentivized experiment in which future inflation affects investment payoffs. They find that most respondents seem to make investment decisions that are consistent with their inflation expectations. To the best of our knowledge, it is still an open question whether household beliefs and actions are jointly consistent with the individual׳s views about monetary policy. Our paper is a first step in this direction. Given the importance policymakers attach to communicating policy objectives to the public as a way to enhance its effectiveness, we believe this question warrants further research.