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:
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.
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.
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.