Towards a market-based rule for monetary policy

To what extent was the absence of an effective feedback rule for monetary policy responsible for the excess liquidity and the resulting bubble in housing prices prior to the Great Recession? Although many in the Fed recognize the importance of expectations and forward-looking behavior, some economists think there is still too much emphasis on short-term fluctuation in real variables such as employment, output, productivity and capacity utilization. Rather, the emphasis should be on variables which indicate excess liquidity in the economy and variables which indicate inflationary expectations.  I propose a monetary feedback rule based on the timely information found in market prices and interest rates.  This market-generated information gives an indication of (1) current trend inflation, (2) long-term inflationary expectations and (3) the extent to which the supply of money is growing faster than the demand for money.  Romer and Romer (2000) allowed for agents to react to the informational content of Fed actions. However, if the Fed is using a forward-looking policy rule, market prices and yields may be useful since market participants are, presumably, also forward-looking.  This mutual feed-back between private agents and the central bank is conducive to generating a process that enables inflationary expectations to be anchored.  I first estimate a version of the Taylor rule based on differences in the federal funds rate, similar to Sack (2003). The feedback rule is based on current inflation and inflationary expectation at the one and ten year horizon.  In one version of this rule, I use core CPI to measure current inflation, lags of the CPI to proxy for inflationary expectations at the one year horizon, and the TIPS spread to measure inflationary expectations at the ten year horizon.  I then contrast the Fed funds rate targets based on this rule with the actual targets used by the Fed and with those based on the standard Taylor rule.

The objective of this paper is to argue for a market-based feedback rule for monetary policy.  I expect to show that the proposed policy rule would have resulted in less expansionary monetary policy in the run up to the recent financial crisis.