Financial markets expected the Federal Reserve to react more aggressively to inflation surprises in recent years, compared to before the pandemic, according to new Cleveland Fed research.

Two-year Treasury yields - which tend to rise and fall with the federal funds rate - were much more sensitive to unexpected inflation increases from 2022-2024 than in the pre-pandemic period.

During those years, yields increased by an average of 0.71 percentage points when core Consumer Price Index (CPI) readings were 1 percentage point higher than expected. That's roughly four times the sensitivity seen in 2004-2008 (0.18) and 2015-2020 (0.13).

The report also notes that two-year Treasury yields became less sensitive to other economic indicators (such as core retail sales and new-home sales) over time.

What could explain these changes? The Federal Open Market Committee put greater public emphasis on lowering inflation from 2022-2024, so that messaging could have influenced the market's perceptions. It also could be that investors paid less attention to inflation-related news in prior years when inflation was relatively low and stable, according to the authors, Chengcheng Jia and Alexander Cline.

"Both explanations may play a role in accounting for the change in the market's perceived monetary policy reaction function," they write. "It is also possible that the two mechanisms interact with each other."

Read the Economic Commentary: Has the Market's Perception of the FOMC's Reaction Function Changed since the Onset of the COVID-19 Pandemic?