This may be a bit "wonkish," for some of you, but I believe it captures a crucial aspect of the dilemma the Fed faces right now with respect to Katrina and monetary policy.
The Fed faces a difficult decision in coming months. How should the Fed respond to a supply shock? Theoretically, a negative supply shock should lower the natural rate of output which, for any given level of output, would decrease the output gap. The reduction in the output gap places increased upward pressure on prices and the Fed would respond, assuming inflation targeting, by increasing rates to choke off the inflationary pressure. Caroline Baum, in her column in Bloomberg, stated it succinctly asking, essentially, “Why would the Fed want to increase demand (lower rates) in response to a decreased supply of goods?” That’s a good question. For example, imagine AS=AD=1000. Let AS fall to 900 so that AD>AS. How should the Fed respond if the fall in supply represents a permanent fall in the natural rate? Is there any reason to believe the Fed should pause or even decrease rates to increase demand? Let’s turn to recent remarks by ECB president Trichet from the Symposium at Jackson Hole to begin searching for an answer:
...Why should expectations be a problem within a credible policy environment? Because the economy is never at rest. Agents have to catch up with the continuous change in their environment by an ongoing process of learning. When shocks are moderate … imperfect information and learning do not excessively complicate our interactions with the private sector. But there are times in which … a perpetual process of learning ... can have implications for the overall stability of the economic system – to some extent, independently of the monetary policy regime that is in place. If agents do not possess rational expectations, but have to re-estimate continuously the coefficients of an unknown model of the economy … it can well happen that a shock of sufficiently serious magnitude can unsettle expectations, even under credible monetary institutions. The reason for this is simple. It might become impossible for private forecasters quickly to form a reasoned guess about the scale of the shock, its duration and persistence, and the likelihood that it might not be easily washed away, so that it would become, in their eyes, embedded in the fundamental relations regulating the functioning of the economy for some time to come. Long-term expectations thus may over-react to the shock. They may drift endogenously ... These are times in which, typically, there is a disconnection between private views about the macroeconomic outlook and the central bank’s own internal forecasts. … The difficulty lies in devising a prudent way to factor such situations into policy. And here is where the fundamental tension … comes in. On the one hand we want to keep our eyes on the fundamentals and avoid being misled … by what could well be noise and unfounded overreactions. On the other hand, excess endogenous volatility in private expectations could indeed provide advance warning of pending risks that the central bank should take into account. ... This might entail serious risks of instability. Recent work done at the Federal Reserve Board … shows that, … An aggressive policy adjustment in reaction to detected signs of expectation instability can help head off the risks that one might see associated with the manifestation of such phenomenon. … However, any unexpected and possibly unprecedented action that the central bank takes in response to these risks might disorient the market. … This would suggest that action may not always be advisable. Sometimes, more optimal behaviour consists in appropriately communicating the central bank’s assessment of the fundamental state of the economy and its prospects in order to regain control of inflation expectations. In the long term, the advantages of having systematically avoided hasty reactions outweigh the benefits that might be apparent in the short term. By maintaining a steadier posture, the central bank embracing this policy views its role as that of a lighthouse or, more accurately, a lightship, in a storm. In this respect, building a reputation for a calm and firm management of the events can pay off…
That "It might become impossible for private forecasters quickly to form a reasoned guess about the scale of the shock, its duration and persistence, and the likelihood that it might not be easily washed away..." seems to describe the present situation well. From a learning perspective, an interpretation of this is that private markets have not learned the lessons the Fed has learned from the 1970s and expect a repeat of that episode, i.e. a repeat of the policy of stimulating AD in response to AS shocks. The Fed has made it clear recently that it does not want to see the inflation of the 1970s repeated. The message Trichet is conveying is that with markets widely anticipating a pause in the rate increasing campaign by the Fed, to continue increasing rates would disorient the markets and potentially lead to even more instability. Should the Fed do what it thinks is correct according to the fundamentals, or does it behave according to market expectations it disagrees with? The answer Trichet gives is that you do not do anything rash that might upset the markets (particularly if the Fed itself is unsure of long-term consequences), it’s better to explain, explain, and then explain some more to re-anchor inflationary and other expectations (hence these kinds of comments from the Fed today). Unless FedSpeak can convince markets otherwise (and assuming FedSpeak would want to), it may be prudent from a risk management perspective to pause and wait for expectations of the Fed and the private sector to converge before considering further rate hikes.