The Fed, and rationality

Should the Fed respond to fears of a "credit crunch" by cutting rates (or hinting at a cut) next month? This is not merely a question of narrow mechnical economics, but about the nature of rationality.
Imagine the Fed were to (surprisingly) cut rates. Equity investors could respond to the move in one of two ways:
1. "Easier money is good for shares and the economy, so I'll buy."
2. "Yikes. Things must be even worse than I thought if Bernanke's so scared of a credit crunch that he's been panicked into cutting rates. I'll sell."
Reaction (1) is plain causal expected utility. Reaction (2) is what Robert Nozick called evidential expected utility.
And the thing is, both are plausible principles of rationality. That's why Newcomb's problem is so vexing.
Becuase we can't use logic to tell which principle will dominate investors' thinking, we can't tell whether  a rate cut really would calm their nerves. Traders make their money not by anticipating economic news, but by anticipating reactions to it, which is a different thing altogether.
But things aren't so simple as this. Lets' suppose investors know that the Fed knows all this. Then they could react to a rate cut by thinking: "If the Fed's easing despite fears that we'll react by principle  (2), things must be catastrophically bad. I'll sell."
I suspect it's the fear of this meta-reaction that will (or should) stop the Fed moving next month; we're into the higher moments of reflexivity.
But the implications are wider than a single rate move. This paper (pdf) discusses how it complicates monetary policy. More generally, the fact that rationality is ambiguous means that predicting human behaviour is just far trickier than the so-called experts would have us believe.

Comments

[Meh]

And yet, some, like Bryan Caplan, think there are simple measures by which you can declare the decisions of electorates "irrational" and campaign for (presumably benign) dictatorship...

[cityunslicker]

If it were so easy to predict the markets then I would be having a much improved lifestyle over that currently experienced.

[stan jonas]

CUTTING RATES WOULDN'T BE MUCH OF A SURPRISE ANY MORE