The Economist has an interesting article discussing the interaction between markets and central banks:
Discerning this signal becomes trickier the more the Fed appears to respond to the market. To see why, suppose that the Fed ignores market movements completely, and instead sets policy in an entirely predictable way, responding only to hard data on growth and inflation. Any change in market expectations about Fed policy would then reflect only changes in investors’ perception of the outlook for those variables. “If Fed policy is clear and systematic,” says Charles Calomiris of Columbia University, “policymakers can glean useful information from markets.” The more the Fed responds to the market, however, the more it is “looking in the mirror”, as Alan Greenspan, a former Fed chairman, supposedly once quipped. . . .
If the Fed wants to glean useful information from markets, it cannot pander to them. “The Fed needs to be the dog that wags the tail,” says Mr Mishkin.
Greenspan was referring to what Ben Bernanke and Michael Woodford once called the “circularity problem”. The markets look to Fed policy for direction, while the Fed looks to market predictions for direction. If the markets believe the Fed will respond to a major price movement by taking steps to prevent the economy from going off course, then the markets may fail to send a warning signal that the economy is in danger of going off course.
Here it is important to distinguish between several types of market forecasts. An unconditional forecast of the policy instrument, such as the fed funds interest rate, is not particularly useful. The markets are predicting future Fed policy, but that doesn’t tell us if future policy is appropriate.
The market forecast that the Fed needs to focus on is the prediction of the policy instrument setting that will lead to on-target growth in nominal spending. That’s the point of my “guardrails” proposal for using NGDP futures markets to guide policy.
Mishkin’s wrong—the market should be the Fed’s guide dog. But this requires the creation of appropriate market indicators, which we do not have at the moment. Until then, the best we can do is to look at a pair of indicators, fed funds futures and inflation forecasts. Markets currently expect the Fed to cut rates over the next 12 months, and also forecast that this will not be enough to hit their 2% inflation target. Neither prediction by itself is definitive, but together they suggest that policy is currently a bit too tight.