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Perfecting the market's knowledge of monetary policy

  • William Poole
  • Robert H. Rasche

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.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2000-010.

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Date of creation: 2000
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Publication status: Published in Journal of Financial Services Research, December 2000, 18(2-3), pp. 255-98
Handle: RePEc:fip:fedlwp:2000-010
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  1. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, May.
  2. Athanasios Orphanides, 2001. "Monetary Policy Rules Based on Real-Time Data," American Economic Review, American Economic Association, vol. 91(4), pages 964-985, September.
  3. William Poole, 1999. "Monetary policy rules?," Speech 81, Federal Reserve Bank of St. Louis.
  4. Antulio N. Bomfim & Vincent R. Reinhart, 2000. "Making news: financial market effects of Federal Reserve disclosure practices," Finance and Economics Discussion Series 2000-14, Board of Governors of the Federal Reserve System (U.S.).
  5. Kenneth N. Kuttner, 2000. "Monetary policy surprises and interest rates: evidence from the Fed funds futures markets," Staff Reports 99, Federal Reserve Bank of New York.
  6. John C. Robertson & Daniel L. Thornton, 1997. "Using federal funds futures rates to predict Federal Reserve actions," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 45-53.
  7. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  8. William Poole, 1999. "Synching, not sinking, the markets," Speech 77, Federal Reserve Bank of St. Louis.
  9. McCallum, Bennett T., 1999. "Issues in the design of monetary policy rules," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 23, pages 1483-1530 Elsevier.
  10. Perman, Roger & Scouller, John, 1999. "Business Economics," OUP Catalogue, Oxford University Press, number 9780198775249, March.
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