Dear Ben, Please Surprise Us with a Policy Regime that Never Again Surprises Us

“Left Outside” recent left the following two comments:

It’s all getting quite exciting isn’t it?

and

That’s a bad sign, of course, monetary policy should never be exciting. If it’s exciting you’re doing it wrong.

That’s right.  The central bank is doing its job when monetary policy is incredibly boring.

Then Saturos pointed me to an Arnold Kling post, which starts off quoting one of Arnold’s readers:

if an economist comes up with a novel and correct theory that makes predictions about macroeconomic variables, shouldn’t this theory enable him to beat the markets using these predictions?…

Therefore, it seems that if we accept both the EMH and the basic validity of macroeconomics, the latter must be about predictions that are somehow novel, correct, and non-trivial, but at the same time provide no new information about future market prices, even in terms of crude probabilities. But what would be some examples of these predictions, and what principle ensures their separation from market-relevant information?

Then Arnold adds the following:

Consider financial variables, such as the long-term interest rate or the price-earnings ratio of the overall stock market. According to the efficient markets hypothesis, these are not predictable on the basis of known information. To put this another way, you cannot beat the market forecast for these variables.

On the other hand, in conventional macroeconomics these variables can be predicted using models and controlled using policy levers. Reconciling this with the EMH has challenged economists for decades. Here are various alternative ways of doing so:

1. Policy has no effect. Markets do what they will do, regardless. The market uses the best prediction model, so economists’ macro models can, at best, replicate the market’s implicit model.

2. Policy has an effect, but markets try to anticipate policy. The expected component of policy has no effect. Only policy surprises have an effect.

It seems to me that the market monetarists (e.g., Scott Sumner) believe something closer to (2) than to (1). But (2) can get you into some strange conundrums. Does the Fed have free will? That is, does it have the ability to surprise markets, other than by acting randomly? If its actions are not random, they should be anticipated by markets. If they are anticipated by markets, then they should have no effect. etc.

Here’s what I would say:

1.  The expected part of monetary policy has no impact on financial markets.  It can still impact goods and labor markets, depending on when the policy became expected, and the duration of wage and price stickiness.

2.  Because the expected part of monetary policy cannot move markets, any systematic monetary policy should not involve Fed “surprises” moving asset prices.  If they do, then the policy regime is non-optimal.

3.  If policy is already non-optimal, and expected to remain non-optimal, then markets may be pleasantly surprised if an obscure blogger is able to make the world’s major central banks see the light and “target the forecast.”  That’s a good surprise, but can only occur once—during the transition from a bad to a good policy regime.  After than, no more surprises.  Please.

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