Interpreting the Fed

Here’s a puzzle.

For the first time ever, yesterday at 2pm the Fed released its forecasts for inflation (and other variables) for the next three years.  How should one interpret an inflation forecast for 2010?  Surely this is a statement of what the Fed thinks the “long run” looks like.  Thus, the 2010 inflation forecast – of 1-3/4 percent – is essentially an articulation of the Fed’s inflation target (or at a minimum, its definition of effective price stability).

Now imagine that you are trying to price long-term bonds.  Surely an articulation of the Fed’s inflation target is the most important news all year, if not in several years.  (And surely it is more important than trying to discern whether the short-run forecasts suggest an easing next month, or the month after.)

But markets thought this completely uninteresting.  Take a look at the bond market response:
Bonds_2
Of course, markets wouldn’t respond, if they already knew that this is the Fed’s inflation target.  But I’m not so sure this is accurate.  The Philly Fed’s latest Survey of Professional Forecasters suggested  that the expected inflation target was a bit lower (1.6%), and previously Chairman Bernanke had suggested a “comfort zone” of 1-2%

Even if the markets already understood the Fed’s target then surely the announcement of yesterday’s news at least removed substantial uncertainty, which should have – but didn’t – change the risk premium built into the relative pricing of nominal relative to inflation-indexed bonds.

I am left to conclude that markets are either under-reacting to truly important news, or they are truly prescient and already knew the Fed’s inflation target.  My bet is on the former. 

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  • http://profile.typekey.com/robinhanson/ Robin Hanson

    I was under the impression that these were very thick and well traded markets. I can believe big errors at long term bets at InTrade, where the large transaction costs (mainly foregone interest) and low volume mean there are only modest incentives to correct errors. But it is much more surprising to see errors as large as you are suggesting in interest rate markets.

  • Caledonian

    So maybe it’s not an error.

  • gwern

    “I am left to conclude that markets are either under-reacting to truly important news, or they are truly prescient and already knew the Fed’s inflation target. My bet is on the former.”

    I don’t quite follow this; why couldn’t it simply be that the markets think the prediction is wrong? I personally have a hard time seeing how this prediction could be useful – the target could be devoid of information either because it’s almost certainly wrong or because it’s politically motivated, or any number of other reasons.

  • http://profile.typekey.com/bayesian/ Peter McCluskey

    I traded some bond futures this morning without being aware of that forecast, and I probably wouldn’t have done anything different had I been aware of it.
    It’s not obvious what Fed announcements are useful in predicting future Fed actions. For predictions about where the fed funds rate will be in a few months, the Fed does give some valuable messages (which I infer from the markets, without much understanding of how that info gets communicated).
    For longer term predictions, I mostly assume that the Fed’s actions are largely determined by external economic and political pressures, and I’m skeptical about the value of reading Fed messages about its long term plans.
    I’m also a bit puzzled by the forecast of a 1.6% target. I haven’t been expecting the Fed to actually attempt to keep inflation that low. Remember that that 1.6 number is not a market price, and doesn’t necessarily tell you what expectation is priced into the market. I can imagine there’s some valuable information to be gained from the difference between the Fed’s forecast and the forecasts of “professional forecasters” that I ought to look into, but without having a history of such differences to check I’m reluctant to put much weight on that.

  • Matija

    That is a silly matter to discus. They sure wouldn’t be working for government if they didn’t say that. About markets knowing all is just wrong. Don’t forget a couple of years Mr. Greenspam was worrying about deflation. Author must not bet, and next time must not draw conclusions about the things he knows nothing about.

  • Alan Gunn

    Did you bet a lot? The history of people betting against the market on the basis of publicly available information is not encouraging.

  • http://www.aleablog.com jck

    Non event, 10 year TIPS are at 1.62.

  • http://cob.jmu.edu/rosserjb Barkley Rosser

    This is one of the more ignorant posts I have seen here for some time. It is widely believed that what is going on is that Bernanke (not Greenspan, he has been out for more than a year now) is now sneaking his long-desired “inflation targeting” policy in through the back door. How is he doing it? Well, guess what that 2010 forecast is? It is not a forecast. It is a target, and this has been widely commented on throughout the media and the econoblogosphere.

  • http://www.aleablog.com jck

    Was interrupted.
    Non event, 10 year TIPS are at 1.62, 10 year TN at 4.01 this gives CPI 2.39 and PCE at around 2.00.
    5 year TIPS at 1.11 and 5 year TN at 3.35 this gives CPI at 2.24 and PCE around 1.84.
    2010 implied PCE would be around 1.80.
    Given the margin of error the target/forecast/projection is what is implied by the market.No reason to under/over or react at all.

  • Caledonian

    It seems to me that there are (roughly speaking) three possibilities:

    1) Mr. Wolfers’ judgement is correct, and the market did not respond reasonably to the news.
    2) The market responded reasonably to the news, and Mr. Wolfers’ expectation that they should have responded differently was incorrect.
    3) Both the market and his judgement were wrong.

    What evidence would be sufficient to get us to accept that the market was actually wrong? Same question for Wolfers’ judgement.

  • http://cob.jmu.edu/rosserjb Barkley Rosser

    Just for the record, I apologize for my harsh language.
    However, the substance of my remarks remains.

  • http://profile.typekey.com/jwolfers/ Justin Wolfers

    Barkley, for what it is worth, your comment describes precisely the point of my post. (I didn’t realize I was so unclear.) What Bernanke announced was officially a forecast, but more realistically, was the de facto announcement of the Fed’s medium-run inflation target. The announcement of a forecast is small news; the announcement of the nominal anchor for the US economy during (and probably beyond) Bernanke’s tenure is big news. So then the puzzle is why the bond market didn’t respond to such important news.

    Robin: Your comment is spot on. Equally, while we might believe that markets are extremely well calibrated at responding to the everyday news about economic data, last week’s news was about the medium-run monetary framework. Such changes occur so rarely that it is hard to make strong statements about whether markets have historically responded appropriately to them or not.

  • http://cob.jmu.edu/rosserjb Barkley Rosser

    Justin,

    Thanks for the clarification. Now you look like a wise and smart guy, even if one who did not clearly articulate what you were about.

    As for Robin’s point, it is true that we less frequently see “errors” in these thicker markets. But we still do, most notoriously in the forex futures ones. There is a huge literature on various “premia” that persist without being realized in such markets, and there have been numerous notorious episodes where the markets were just way off, such as during the early 1980s when all the forward markets said the dollar was going to decline, only to see it rise for several years in a row in an episode now widely viewed in retrospect as a large speculative bubble.

  • http://cob.jmu.edu/rosserjb Barkley Rosser

    Oh, just to add, I forgot to bring in interest rates. That period in the early 1980s also had massive failure of uncovered interest parity, with interest rates in general not performing all that well in conjunction with forex markets.

    As for the markets not reacting to this new development, I think that they have already been assuming that Bernanke and crew have been inflation targeting. The only news here that might have moved the markets would have been if the apparent inflation target was something unexpected. That not being particularly the case, there is no particular reason for them to have done anything, so nothing to get all worked up about here at all.