Market monetarists have often pointed to the Fed’s pathetically weak response to the financial crisis of 2008. For instance, the Fed met two days after Lehman failed in mid-September, and refused to cut their fed funds target (which was 2% at the time), citing an equal risk of recession and inflation. In fact, the day of the meeting the 5 year TIPS spread was only 1.23%, which is roughly the actual inflation rate since that time.
Why did the Fed adopt such a tight money policy in 2008? Because they were operating a backward-looking policy regime and inflation had been relatively high over the previous 12 months. It’s like trying to drive a car by looking in the review mirror, and making adjustments when you are edging off the road. In contrast, market monetarists want the Fed to look down the road, and steer to a point on the horizon. We want the Fed to use market forecasts. Now we have Narayana Kocherlakota making a similar argument:
Basic economics says that a policymaker should set a policy instrument so that, on the margin, there is no net benefit to altering it. But while the policymaker’s decision is necessarily made today, the resultant costs and benefits are realized only in the future. Therefore, the policymaker’s optimal choice is to set the policy instrument so that the outlook for the future marginal net benefit is zero. In this talk, I address the following question: How can the policymaker formulate the needed outlook for marginal net benefits? Policymakers often attempt to do so by using statistical models to forecast future marginal net benefits. I argue that policymakers can achieve better outcomes by basing their outlooks on risk-neutral probabilities derived from the prices of financial derivatives.
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After presenting my general argument, I illustrate it using the example of a central bank that has a single mandate of targeting an inflation rate of pi_bar. Monetary policy operates with lags, and inflation is affected by shocks other than the central bank’s decision. Hence, the best that the central bank can do is to ensure that its medium-term outlook for inflation always equals pi_bar. My general argument implies that the appropriate outlook for the central bank is not a statistical forecast of inflation, but rather the risk-neutral expectation of inflation, calculated using risk-neutral probabilities. This risk-neutral expectation can be measured using inflation break-evens on assets like zero coupon inflation swaps or TIPS bonds. Hence, it is optimal for an inflation-targeting central bank to follow policies that ensure that inflation break-evens remain close to pi_bar.
I don’t have much to add, except to note that the Fed has a dual mandate, and thus would need a market forecast of the macro variable that would best correlate with their dual mandate. If you have any suggestions for such a variable, please write Kocherlakota and tell him the Fed needs to create a futures market for that dual mandate indicator ASAP.
Update: Here’s an excellent Michael Darda interview on Bloomberg.tv. He uses one of David Beckworth’s most effective graphs to show how the European debt crisis is fundamentally a monetary crisis.