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June 14, 2006

Questions for Bernanke

US monetary policy is getting interesting. Mark Thoma says:

If expectations are overwhelmingly for 5.25%, I don't think the Fed will be willing to surprise markets and pause anyway.

This raises some questions:
1. What if market expectations are irrational - say because herding or information cascades are causing everyone to worry too much about inflation? Should the Fed follow an irrational herd?
2. Is there a danger that higher rates might actually validate high inflation expectations? The private sector might regard a rate rise not as a sign that the Fed is willing to reduce inflation, but rather as confirmation that inflation is indeed a big risk. If higher interest rates lead to higher inflation expectations,  they lose much of their power to reduce actual inflation.
3. Whatever happened to Brainard conservatism? This is the idea that interest rate moves should be modest because central banks need to learn about their effect upon the economy. Doesn't this argue for the Fed pausing?
4. Contrarily, there can be a case for the Fed taking very aggressive action. This paper (pdf) argues that gradual interest rate moves can fail because they do indeed validate private sector expectations. Policy,  say Andrew Caplin and John Leahy "needs to be more aggressive than the reaction it seeks to elicit."
5. Given these uncertainties, could it be that the case for the Fed doing what the market expects is not that this is the right thing to do, but simply that - from the Fed's point of view - it  is the least expensive mistake to make?  As every forecaster knows, if you're going to be wrong, make sure you're wrong in a crowd.

June 14, 2006 in Monetary policy |

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Comments

dearieme

Bernanke, I understand, believes that the Fed was the cause of the Great Depression, or at least of its untypical depth. I suspect that he'll be the fall-guy for the next one. I wonder how one gets out of a great depression in a world of fiat currencies?

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