Macroblog reports that the markets are unusually uncertain about where the fed funds rate is heading. Could it be that one reason for this is that the Fed faces a version of Newcomb's problem?
To remind you, the problem is as follows.
A super-being, with amazing powers to predict your behaviour, offers you two boxes. In one, there is $1000 for certain. In the other, there is either $1 million or nothing.
The being offers you a choice: to take only the $1m or nothing box, or to take both boxes.
The catch is that he put the $1m into the box yesterday only if he has predicted that you'll take that box alone. If he predicted that you'll take both boxes, he left it empty.
What do you do? There are two theories.
Evidential expected utility: I must take only the one box. The super-being has predicted that I'll do this, and has kindly put $1m in. If I take both boxes, he'll have predicted that too, and put nothing in the box, so I'll have only $1000.
Causal expected utility: The $1m is either in the box or not by now. My choice won't affect the contents. So I must go for both boxes. That way, I'll pick up $1000 for sure, with a chance of the $1m.
Everyone's argued the toss over this puzzle for ages. The message Robert Nozick - who brought the puzzle to wider attention* - took from it is that there are two valid but contradictory ways of taking decisions. Rationality is not the clear-cut concept we think it is.
What's this got to do with monetary policy?
Plenty. The Fed could think like this.
Evidential expected utility: if we hold off from raising rates, the private sector will take it as a signal that we - the experts - are worried about the economy. They'll therefore start worrying too, and cut spending and investment. We'd better raise rates rather than surprise people.
Causal expected utility: A rate pause will simply cause the economy to be stronger than it would be if we raised rates. So let's take out a little insurance against the possibility that Katrina will have serious effects on activity. That's Macro 101.
Two decision rules conflict.
If you think this is absurd, consider this paper (pdf) by Andrew Caplin and John Leahy. They describe a model in which private agents respond to interest rate cuts by cutting spending, because they anticipate more economic weakness and rate cuts, with the result that gradualist monetary policy is counter-productive.
And if you think this is tricky, here's a further wrinkle. Causal and evidential rationality, said Nozick, are not the only forms of rationality. There's also symbolic rationality; some things (like voting?) are worth doing not because they make us materially better off, but because they symbolize who we are.
Introducing this form of rationality gives us a further dimension to the Fed's decision. Does it want to symbolize that it's keen to fight an inflation threat, or that it's sympathetic to those hurt by the effects of Katrina?
It's no wonder the market's confused.
* in this superb book. FWIW, I reckon too many people are Nozickeans because of Anarchy, State and Utopia, and not enough are Nozickeans because of this.