Perfecting the Market's Knowledge of Monetary Policy

Abstract

The rational expectations revolution made clear that a complete macro model requires a specification of the government's economic policy. We argue that monetary policy should be conducted in such a way that the market can predict policy actions. An implication of market success in predicting policy actions is that interest rates move ahead of the policy actions, and such a timing relationship may appear to some as the central bank following the market instead of leading it. Another implication of the market predicting policy actions is that nominal interest rate changes provide no useful information to the central bank about the strength of aggregate demand or inflationary expectations. Finally, failure of the market to predict policy actions reflects a problem that needs to be addressed.

We explore the theoretical implications of a monetary policy that is completely specified and perfectly understood by the market. We construct a bare-bones model to illustrate the key concepts. Finally, we conduct an empirical investigation of these issues, especially in the context of monetary policy since 1988, when the establishment of the federal funds future market made available well-defined market information on expectations about Fed policy actions. We find that when the intended funds rate is changed, interest rates over the maturity spectrum respond to “news” measured by changes in the one-month-ahead funds futures yield but do not respond to the anticipated component of the change in the intended funds rate.