A new economic commentary from the Federal Reserve Bank of Cleveland examines how unexpected changes in monetary policy affect household sentiment, revealing that the impact depends significantly on the prevailing inflation environment. Researchers Alexander Cline and Chengcheng Jia analyzed data from May 2004 through November 2024 using the University of Michigan Consumer Sentiment Index (MSCI) to measure household attitudes regarding personal finances and the broader economic outlook. The study employed high-frequency monetary policy surprises, defined as unexpected changes in the federal funds rate within a 30-minute window around Federal Open Market Committee (FOMC) meeting announcements.
The initial analysis following conventional economic theory found that monetary policy surprises had no significant linear effect on household sentiment, regardless of whether other macroeconomic news was controlled for. This held true even when the analysis excluded the COVID-19 pandemic recession period from March 2020 to March 2021. The researchers also found that separating prepandemic and postpandemic responses did not yield statistically significant differences.
However, the research reveals a state-dependent relationship when the inflation environment is considered. When inflation was low in the month prior to a monetary policy decision—defined as a month-over-month headline CPI change below 0.2 percent—an unexpected policy rate hike significantly boosted household sentiment. Specifically, a one-standard-deviation increase in the monetary policy surprise was associated with a 1.43 percent increase in the MSCI during low-inflation periods.
Conversely, when inflation was high in the previous month—defined as a month-over-month headline CPI change above 0.2 percent—an unexpected policy rate hike significantly depressed household sentiment. Under these conditions, the same one-standard-deviation increase in the monetary policy surprise was associated with a 1.38 percent decline in the MSCI. These results remained consistent when alternative definitions of high inflation were employed, such as month-over-month CPI changes above 0.3 percent.
The researchers interpret these state-dependent findings through the lens of rational inattention theory and the information effect of monetary policy. When inflation is low and stable, households tend to pay minimal attention to macroeconomic news because the benefits of being informed are low. In this environment, unexpected monetary policy decisions may signal information about the broader state of the economy.
Households might interpret an unexpected rate hike as evidence that the Federal Reserve believes the economy is stronger than previously thought, thus boosting sentiment. In contrast, when inflation is high, households are more attentive to macroeconomic conditions and possess relatively precise information about the state of the economy. In this case, an unexpected rate hike is perceived simply as an increase in borrowing costs without conveying additional information about economic strength, thereby depressing sentiment in line with standard New Keynesian economic theory.
The study notes that the average monthly change in the MSCI was lower in the post-pandemic-recession period from April 2021 through November 2024 compared to the full sample period from May 2004 to November 2024. The average monetary policy surprise was positive during the postpandemic period, indicating that actual monetary policy proved tighter than expected, though this difference was not statistically significant. The findings contribute to the broader academic debate about how households respond to macroeconomic information.
Previous studies have yielded mixed results, with some research suggesting that unexpected policy tightening leads to immediate deterioration in household sentiment, while other studies have found that households are largely inattentive to macroeconomic information compared to professional forecasters and financial market participants. The Federal Reserve Bank of Cleveland published this research as Economic Commentary 2026-20 on August 31, 2026. The commentary is part of the Cleveland Fed's ongoing effort to inform policymakers and the public about economic issues affecting communities across the nation.
Source: clevelandfed.org