Main Street Monetary Policy: The Implications of Business and Consumer Sentiment for the Federal Reserve

Abstract

The utility of sentiment measures in monetary policymaking has only been sparsely studied and increasing in importance as sentiment diverges from economic fundamentals. This paper seeks to answer two questions. First, has the Federal Reserve historically incorporated business and consumer sentiment into their policymaking? In addition to existing sentiment indicators, this paper constructs a first-of-its-kind index of business sentiment derived from AI-enabled textual sentiment analysis of Beige Book reports. This approach enables us to capture business sentiment flowing directly to the Federal Reserve, its geographic variations, and offers flexible insights into specific sentiment attributes. Resulting evidence shows that the Federal Reserve has been historically responsive to business but not consumer sentiment in its rate-setting. This paper also finds these sentiment measures to be more reflective of labor market than price level conditions. Notably, this paper finds discernible heterogeneity in this relationship across different Federal Reserve chairs. Second, should the Federal Reserve incorporate business and consumer sentiment into their policymaking? Combined with evidence that sentiment measures predict real economy outcomes, I present a mathematical model demonstrating how sentiment flows through the real economy and necessitates changes in the monetary reaction function. Lastly, I simulate the estimated monetary regimes in a general equilibrium model and find that sentiment-augmented monetary regimes produce significantly superior real economic outcomes compared regimes ignoring sentiment. Broadly, this paper provides evidence that a greater sensitivity to the sentiments of real economic actors can produce better monetary policy.