Expectations and Monetary Policy

Yglesias:

Planet Money did an enlightening explanation of what an “operation twist” effort might look like for Morning Edition today, but it said something that I want to take issue with, namely the claim that “[t]he Fed has at its disposal one key tool: interest rates.” This is certainly what certain popular models say, but it doesn’t really make sense theoretically.
My thinking on this has been influenced a lot by the group of people who I guess we’re now calling “Market Monetarists” (PDF) but is arguably closer to the Old Keynesian view outlined in Chapter 12 of the “General Theory”. Specifically, this beauty contest issue:

Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

The thing is, this works for the economy as a whole. If households anticipate rising incomes, they’re more likely to buy things. And if firms anticipate rising sales, they’re more likely to expand activities. And if firms expand activities, incomes are more likely to rise. So optimism about the state of things can be self-justifying. This isn’t a magic trick. If firms face binding constraints on their ability to produce, no amount of optimism will change that fact and all economies do face objective scarcities of natural resources and appropriately skilled labor. But within the range of objectively possible production, there’s a range of plausible outputs and expectations are crucial to determining how closely actual output matches potential output. Yet, as in Keynes’ beauty contest there’s this terrible indeterminacy. What do I expect the average expector to expect me to expect? What’s needed, in essence, is for someone to show up and tell us what to expect.
In this view, the key thing about the modern central banker is simply that we’ve all agreed that he’s the guy in charge. “Don’t worry folks, if your business is profitable you should be expanding production because all the other profitable businesses will also be expanding so there will be customers for your profitable products.” It’s a social convention, and the convention is self-validating. As long as we all agree to agree that we’ll agree that what the central bank says is important, it is important. This is why central banking is cloaked in mystery, why it’s “apolitical,” while meeting transcripts need to be delayed for years, etc. Central bankers have generally preferred to use short-term interest rates as their tool of choice, but this is fundamentally just one of the Wizard of Oz’s tricks. In an ideal world, the head of the bank would go on television waving a stopwatch and hypnotize the audience. To boost output say: “at the margin, you will on average decrease your interest in owning dollars and dollar-denominated safe liquid financial instruments.” To curb inflation say: “at the margin, you will on average increase your interest in owning dollars and dollar-denominated safe liquid financial instruments.” But of course everyone knows that stopwatches can’t really hypnotize people, so they use interest rates instead. With short-term nominal interest at zero, bankers need to pick a different instruments but there are plenty of things they could choose. What matters is that they choose something and back it up with some bold talk about how people are going to want to own fewer dollars and dollar-denominated safe liquid financial instruments.
This is all sounds kind of nuts, because it is. That’s why New Keynesians want to believe it’s all about interest rates and it’s why Market Monetarists like to daydream about an NGDP futures market. I think the world’s just a bit weird and nutty.