Despite rising inflation in 2021, financial forecasters consistently expected policy rates to remain at zero. It was only after the Federal Reserve initiated rate hikes in 2022 that market participants updated their perceived policy reaction function. pflueger identifies this dynamic as the 'learning from actions channel,' showing that communication alone failed to shift expectations until concrete rate changes occurred.
Long-term US inflation expectations have remained largely anchored. Pflueger's research shows that the rise in the 10-year Treasury yield from 2020 through 2025 was primarily driven by Treasuries becoming more stock-like. Because Treasuries now positively co-move with equities instead of acting as a hedge, investors demand a higher risk premium to hold them.
Treasury bonds act like stocks when supply-side inflationary shocks hit the economy and central banks are forced to accept recessions to fight inflation. During demand-driven shocks, falling inflation benefits nominal bonds during downturns, preserving their negative correlation with equities. Recent stability in inflation expectations combined with inertial monetary policy has kept bond risk lower than in the 1980s.
When the market clearly grasps the Federal Reserve's policy reaction function, bond yields automatically adjust following economic data releases like CPI or employment. This dynamic allows markets to implement monetary conditions aligned with Fed intentions ahead of FOMC meetings, effectively doing the central bank's transmission work in advance.
Historically, bond market depth and military dominance reinforced one another, as seen in Britain and the US. However, Pflueger's model indicates that at very high levels of borrowing capacity and debt-to-GDP, financial market perceptions can become self-fulfilling. If markets deem a nation safer and grant lower financing rates, that country can fund superior economic and military advantages without a war.
The public's perceived policy reaction function is not constant. Historical analysis of forecaster data indicates that the perceived reaction to output steepens during tightening cycles, when central bank leaders stress data dependence. Conversely, during easing cycles, rate cuts are often sudden and followed by lower perceived sensitivity, causing the reaction function to flatten.