Why Monetary Policy Works Better in Booms Than During High-Inflation Slowdowns

The study shows that the relationship between inflation, growth, and interest rates changes sharply across different economic conditions, making monetary policy far more effective in inflationary booms than during periods of high inflation and weak growth. It concludes that one-size-fits-all models miss these crucial differences, and central banks must tailor their actions to the economic regime they face.

For years, central banks have relied on economic models that assume inflation, growth, and interest rates interact in stable and predictable ways. But new research from the European Central Bank and the University of Notre Dame challenges that assumption. In a detailed study of US economic data spanning nearly six decades, economists Dario Cardamone and Roberto A. De Santis show that the relationship between inflation and output changes sharply depending on the state of the economy. Their conclusion is straightforward but powerful: monetary policy works very differently in booms than it does in downturns, and especially differently when inflation is high.

Four Economic Worlds, Not One

The study divides the economy into four distinct phases using two benchmarks familiar to policymakers: whether inflation is above or below the Federal Reserve’s 2 percent target, and whether economic output is above or below its potential. This creates four regimes, disinflationary slack, inflationary slack, disinflationary boom, and inflationary boom. Rather than treating the economy as operating under one set of rules, the authors allow key economic relationships to shift across these states.

Using monthly US data from 1962 to 2019, they estimate a nonlinear model that captures how inflation, output, and interest rates interact differently depending on which regime the economy is in. This approach reflects the reality faced by central bankers, who must respond not just to data, but to the broader economic environment behind the numbers.

The Central Bank Rule That Still Holds

One reassuring finding is that the Federal Reserve has followed a consistent principle across all economic conditions. Known as the Taylor principle, it requires interest rates to rise more than inflation, ensuring that real borrowing costs increase when prices accelerate. The study finds that this rule holds in every regime, whether the economy is strong or weak.

However, how strongly the central bank reacts to growth does vary. When inflation is low and the economy is expanding, policymakers respond less aggressively to changes in output. When inflation is high and growth is weak, they become more cautious and more responsive to incoming data, adjusting interest rates with less delay and less emphasis on smoothing changes over time.

Why Inflation Becomes Harder to Control in Booms

The most striking result concerns the Phillips curve, which links inflation to economic activity. Many economists have argued that this relationship has weakened over time. This study shows that it hasn’t disappeared, it has become conditional. When inflation and output are both high, the Phillips curve becomes much steeper, meaning that small increases in demand can lead to large increases in inflation.

This pattern was especially strong during well-known overheating episodes, including the 1970s inflation surge and the years before the global financial crisis. In contrast, when inflation is low, the relationship flattens, making it harder to bring inflation down without significant economic pain. In simple terms, inflation is easiest to ignite when the economy is hot and hardest to extinguish once it takes hold.

Why Interest Rate Hikes Sometimes Feel Ineffective

The study also explains why monetary policy can feel frustratingly weak during certain inflation episodes. When inflation is high, but the economy is still sluggish, a situation known as inflationary slack, raising interest rates has a limited effect on growth. Households and firms are less responsive to interest rates when inflation erodes the value of savings and income.

Paradoxically, this is also the period when central banks intervene most forcefully. The research shows that monetary policy shocks are much larger when inflation exceeds its target, especially during inflationary slack. Yet despite these stronger actions, the economy reacts less, making inflation harder to control without risking deeper slowdowns.

Lessons for Today’s Policymakers

The paper’s message is clear: one-size-fits-all economic models are not enough. Monetary policy is most powerful during inflationary booms, least effective during inflationary slack, and relatively forgiving when inflation is low. Mistiming interest rate decisions, especially delaying action during demand-driven expansions, can lead to overheating and force harsher corrections later.

For central banks navigating today’s uncertain inflation landscape, the lesson is simple but crucial. Understanding which economic regime the economy is in may matter just as much as knowing the inflation rate itself.