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Sunday, December 09, 2007

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.

    Posted by on Sunday, December 9, 2007 at 12:33 PM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (17)

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