Q&A: Carolin Pflueger On How New Insights from Financial Markets Can Shape Monetary Policy

Carolin Pflueger is an Assistant Professor at the Harris School of Public Policy. She is also a National Bureau of Economic Research (NBER) Faculty Research Fellow and Centre for Economic and Policy Research (CEPR) Research Affiliate. Her research is at the intersection of macroeconomics and finance, with a particular focus on understanding the macroeconomic drivers of financial markets.

As monetary policymakers reckon with historic levels of inflation, we recently sat down with Carolin to learn what her work could reveal about this critical moment.

Can you share a little bit about yourself and your background?

I’m an economist, and my research focuses on the relationship between macroeconomics, or broad fluctuations in the economy, and the more volatile world of financial markets, such as stocks and bonds. I think this connection is incredibly important for making macroeconomic policy decisions because the data in financial markets is much more accessible and fast-paced. It can often serve as an early indicator of what’s to come.

What sparked your interest in this relationship between macroeconomics and financial markets?

One year after I started graduate school, The Great Recession began, which of course triggered a series of momentous, interesting changes to monetary policy and significant concerns about deflation (hard to imagine now!). Financial markets reflected these very real concerns about a falling price spiral, but were of course also affected by everything else that was going on. Trying to disentangle these macroeconomic forces from risk premia and liquidity was an important motivation for me at the time, and I ended up doing research in this area.

You recently examined why changes to the federal funds rate have such a big impact on the stock market. What did you find?

We tend to think that a central bank like the Federal Reserve raises interest rates to cool the economy and preempt the risk of inflation. But it’s not entirely clear how the Fed is able to do this, and how these effects show up in the stock market. Does the stock market provide real-time evidence that monetary policy stimulates the real economy? Or, conversely, does monetary policy drive the stock market by calming or exciting investors’ nerves, separate from its real effects?

We make the case that these are not separate questions, but instead indicators of a twofold effect. First, there’s the direct effect. Raising interest rates makes it more expensive for households to borrow, thus reducing consumption and earnings and ultimately prices fall. But there’s also a second, indirect effect. As investors struggle to generate returns, they become more risk averse and shift to safer investments like bonds. Thus, stocks fall even more.

We’re currently witnessing the fastest pace of annual inflation in 40 years. What can we learn about this current moment from your work?

We’re living in very interesting times right now because the sources of inflationary shocks are changing. While in the past 20 years inflation was mostly demand-driven, we now have much more reason to be concerned about shortfalls in supply and rising energy prices. This is a much more concerning type of inflation that could impact our standard of living.

I think the financial markets could give us an early indicator of whether supply-driven inflation is continuing to take over. Based on my research on inflation and asset prices, I follow the correlation between Treasury bond markets and the stock market pretty closely. When inflation expectations rise, this is bad for bonds, because a fixed number of dollars can buy less when prices rise. Since around 2000, Treasury bonds have generally risen when there was bad news for the stock market, indicating that there was very little risk of a so-called stagflation – or a scenario where inflation rises just as the world experiences a recession. Since the pandemic, this correlation has sometimes dipped into positive territory, indicating that concerns about supply-driven stagflations may become more prominent.

What do you think the next evolution of monetary policymaking looks like?

Monetary policymakers have incredible research departments, with access to the best financial data in the world. But it always strikes me that their analysis of macroeconomic models is separate from financial markets. I’d like to see a more unified framework that brings both sets of data together in a more systematic way, and that’s what I’m hoping to bring to the discussion.

Why Harris?

We have fantastic students here. I particularly love the international perspective that students bring to the classroom, as well as the public policy perspective. The most interesting part about teaching is when students bring in their own experiences. We have students who have done everything from public policy consulting to shaping policy at central banks around the world. Because of this, they always challenge me with very interesting questions.

What research areas are you excited to explore next?

I’m excited to explore how credible the Fed’s monetary policy framework is, and how perceptions of the Fed’s framework change over time. For example, when the Fed says that it will raise interest rates as soon as the economy overheats, do forecasters and the public actually believe the message the Fed tries to communicate? I’m currently working on estimating the perceived monetary policy rule from rich survey data to understand how these perceptions impact the Fed’s ability to move long-term interest rates.