Working Paper

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, the 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.

Keywords: Monetary policy; Federal funds rate;

Status: Published in Journal of Financial Services Research, December 2000, 18(2-3), pp. 255-98

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2000

Number: 2000-010