Expectation Validation, Stability, and Commitment to a Monetary Policy Rule

I've been thinking about the way in which the Fed has been validating the expectations of financial markets when it makes rate decisions recently, or at least has appeared to do so, and wondering about the features of such a policy (whether or not expectation validation actually characterizes the Fed's behavior).

I've been asking around, and I don't know of a model that actually shows this, but it seems like continuous validation of financial market expectations could lead to unstable paths for the economy, at least over some time frame. If that is in fact a worry, and I think it is, then the question becomes how to avoid it.

The argument is that the Fed cannot risk doing something unexpected - particularly if the unexpected move is to tighten - without the risk of severe disruption in financial markets and the overall economy. Even if the risk is small, a risk management strategy forces the Fed to move in the direction that avoids a dire outcome as might occur if the Fed does something different than financial markets expect it to do.

This may be where commitment to a policy rule such as some version of a Taylor rule could be important. With commitment to a rule, and the credibility to back it up, when the rule says to move in a direction that is different than markets expect, say to hold or tighten, the Fed can convincingly point to the rule in its communication with the public and alter expectations to coincide with its intentions (thus avoiding the dilemma).

But I haven't fully worked this out (and really should get to grading I have to do), so I'd be curious to hear (a) if you think the Fed is trapped in this box of being forced to validate market expectations to avoid the possibility of sending the economy into a tailspin, and (b) if commitment to a rule is a means of avoiding potentially unstable paths that might result from such an expectation validation policy.

Update: Angus at Kids Prefer Cheese has more.

Comments

[calmo]

I see barry payne is an economist (see I'm not so encumbered, you?) and I realize (about 2 secs of introspection is all I can handle, you?) that I don't even have modelsI've been asking around, and I don't know of a model that actually shows this, but it seems...let alone advisors (like Obama)[See, I could just wing it and B Alright...without model thingies.]
I, too, am pressed for time though(a) if you think the Fed is trapped in this box of being forced to validate market expectations to avoid the possibility of sending the economy into a tailspin, and the Nabob (way more than an ordinary advisor or some fancy model with well turned ankles, people
http://naybob.blogspot.com/
has scooped me [calmo -ugly ankles] in any case.

[Rajesh Raut]

The Fed does not have a magic wand. Even if the Fed slavishly followed market expectations, there is no guarantee that the markets will not fall into a tailspin anyway as the crefit bubble de-leverages. Monetary policy can not be dictated by simple rule or consulting a magic 8 ball. The Federal Reserve is in trouble because they do not understand the current crisis. Curing it using the same old witch-doctor medicine of low interest rates is all that they know.

[gordon]

I think Rajesh Raut is right, but let's not forget that the Federal Reserve is a banking regulator, not the US Govt. It can only do certain things, which may or may not be appropriate for a particular situation. I've often been surprised by posts and comments which concentrate on the Federal Reserve to the exclusion of executive and legislative branches of the Federal Govt., as though the Federal Reserve is the only actor on the stage. Expecting it to do things it was never set up to do isn't fair and isn't useful. Where are the discussions of what Congress should do? Why has there been so little discussion (before the Paulson plan) of what executive Govt. should do? And I'm not even raising the issue of what State Govts. should do, which is yet another range of possibilities.

[Predictions Markets Tend to be Reasonably Accurate]

They may have just guessed right a few times in a row.

[barry payne - economist]

Bernanke indeed was sworn in with the understanding he would employ rules rather than conducting the on-the-street (couch) industrial psychoanalysis undertaken by Greenspan.

After consulting with someone steeply experienced in validating expectations on a global scale, Bernanke decided to adopt this rule.

The Unknown Rule

As we know,
There are known knowns.
There are things we know we know.
We also know
There are known unknowns.
That is to say
We know there are some things
We do not know.
But there are also unknown unknowns,
The ones we don't know
We don't know.

My favorite was something like "a mistake can be expected or unexpected - if expected, then it's not a mistake."

[calmo -hunter and gatherer]

"steeply experienced", barry, as in rock climbing or jumping out the window?
I do appreciate your creative genius here...I think...veering away from those worn-out "steeped in relevant experience" or that old saw "deeply experienced" (as in meditation...but also...gumboots) and MEGO expressions.
Personally, the only relief I get from this whole mess is reflecting on our good fortune to have the intelligence of Bernanke as the Fed Chairman. Truly, the only GWB appointment that was in the interests of the country.

[Winslow R.]

On the one hand we have the realistic view that bank failure is a Fed failure.

On the other hand we have the mistaken belief that inflation is controlled by the Fed and therefore is a Fed failure.

Which to sacrifice, the realistic view or the mistaken view? Hmmmmm.

[archer]

I think (and this doubtless makes your modeling issue more complicated) that market participants now believe they can bully the Fed by "demanding" rate cuts via Fed futures prices and dare the Fed to risk market disruption. In more stable times, the Fed might not be cowed, but many observers think it is right now.

[barry payne - economist]

One the one hand we have the unrealistic view that business cycles cannot be generated exclusively in the private sector ... that their only reason to exist is due to the absence of a gold standard, or at least the absence of a constant growth rate of nominal money supply designed to match the real (maximum) growth rate in GNP consistent with zero inflation.

In Milton Friedman terms, the policy is "Don't do something, just stand there".

On the other hand, we have the realistic view that if we wait till business cycles correct themselves, we're all dead in the short run because they're asymmetric in force and direction, so use the money supply to offset them, whether by rule or case-by-case action, and encounter mild inflation as a consequence.

[Winslow R.]

"On the other hand, we have the realistic view that if we wait till business cycles correct themselves, we're all dead in the short run because they're asymmetric in force and direction,

**If we are dead in the short run we'll be dead in the long run as well. Better bailout the banks through fiscal policy. Great little system.

so use the money supply to offset them, whether by rule or case-by-case action, and encounter mild inflation as a consequence."

**Fed adjustments to the price of money (as the Fed hasn't adjusted supply since Friedman) help/hinder intermediators with only an indirect impact on inflation. Bank profits are directly affected.

[calmo -hun]

The double star, (**) Winslow, in front of some paragraphs...means?...we are supposed to belt them out in our best Pavarotti impersonation? [I do anyhow...I might B redirected.] Is there any attendant sound clip? (Recall this is the symphoniacs and I do miss some cues...and some clues too.) The sound of a trumpet would be good...(you know, the one before "Charge!").

Ok, not a word about the squeezitiz on the Fed as our foreign investor friends, PBoC and BoJ, for whom we have such phrases as "the kindness of strangers"...meaning they are getting a lousy return on their tbills, take a recess. So far a loooooong recess for Japan, yes? How far away can higher interest rates be if we have to rely on the kindness of private investors?
***Tadaaa (the sound clip here: http://www.youtube.com/watch?v=1sYnoISYxrc

[Winslow R.]

Calmo wrote: "How far away can higher interest rates be if we have to rely on the kindness of private investors?"

**There is no 'need' to rely on private investors. The Fed could lower the discount rate to the fed funds rate and open the discount window to all (or at least to small and medium size banks). It may take a step towards such an opening the next meeting which would increase 'access' to supply.

[Jared Bernstein]

I think what you describe is very interesting and problematic, because I think it's a recipe for speculative bubbles. And, in fact, the last two recoveries, ie, the 1990s recovery and maybe this one, have fallen prey to bubbles.

One problem with your formulation re the Taylor rule is that I think that if you plot the Fed funds rate over the recent period against a Taylor rule, the lines are pretty much the same. So I'm not sure following the rule gets you out of this pickle.

[knzn]

If the Fed finds itself in a box, that is purely a problem with its communication strategy. Investors acting in their individual self-interest cannot "bully" the Fed, at least not intentionally. If investor expectations between meetings do not correspond to what the Fed thinks is optimal, the Fed should make its hints stronger. If necessary, they can send someone to say, "If a rate cut is proposed at the next meeting, barring unexpected changes between now and then, I will vote against it.". And if that doesn't work, send someone else to do the same thing.

[calmo]

knzn, with this bit:

"If the Fed finds itself in a box, that is purely [there was a time when calmo, too, was on a quest for Purity...then the parentheticals invaded] a problem with its communication strategy."

are you suggesting that they need a Press Secretary?
Does the presence or absence of this office impair of enhance that "communication strategy"?
At this very moment, do I need a press secretary to enhance my communication strategy with you? (Do youall need press secretaries to enhance your communication strategies with me?)[calmo demodem demodems...]

Why is the composition of the Fed, the appointments rather than elections to this body in particular, such an uncommunicable part ...of that communication strategy? Why izit that we need to suspend any preconceptions of investor bias given that composition? You figure I'm just bein a bully? (And you deserve more respect...?) [before you pull the plug, put my lights out, or worse?]

Last unsettling thing: you figure the Notes about the meetings that are released a couple of weeks after (It takes them that long...to remove the expletives?) enhance the transparency as intended (or like this parenthetical: not exactly as intended, no.)?

[kharris]

What archer said.

I would note that Fed funds futures markets have in recent inter-meeting periods swung between expectations of no change to expectations of a 50 ease and back to 25 bps. If expectations are that variable, and changing them no more expensive than it apparently is, why is it that the Fed disappointing expectations is deadly? If the Fed is trying to avoid disappointing market expectations, I hope it is only doing so, as archer suggests, because of the circumstances we now face. Otherwise, I don't see evidence that disappointing markets is expensive, on net.

I also think that if disappointing markets is expensive other than in troubled times, it is because market participants make it so. Disappoint them, and they will take steps to minimize the cost of being wrong, as well as taking steps to align themselves better with Fed guidance.

[calmo 's press secretary]

That disparity of wealth illustrated by 1% owning 2/3 of the market accounts for some of the deterioration archer mentions in those "more stable times", yes?
The Futures market being a tiny subset of that market and not necessarily a subset of that 1%, yes?
The clout of the 1% being the post maul and the Futures, the tiny and fickle tack hammer, yes?