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Synching, Not Sinking, the Markets
Meeting of the Philadelphia Council for Business Economics
Federal Reserve Bank of Philadelphia
Philadelphia, Pennsylvania
August 6, 1999


have long been fascinated with the study of
market responses to policy actions. Prices
in speculative markets respond sensitively
to events, including policy actions and
hints about policy actions, of all kinds. The markets I am referring to include the equity, bond,
commodity and foreign exchange markets. Policy
actions include those by the Federal Reserve, the
executive branch of the federal government, the
Congress, courts and many other governmental
bodies. Although today I will discuss this topic
in the context of Federal Reserve policy actions,
I mention the wide array of markets and governmental units to emphasize that the subject is a
very broad one indeed.
My interest in market responses to policy
actions has only been heightened by my still-new
job as St. Louis Fed president. I have found myself
puzzling over market reactions to Fed policy and
speculation about Fed policy. I am certainly
acutely aware of the fact that what Fed officials
say can move markets. The issue for me is how to
understand market responses at a deeper level,
because I think improved understanding will
strengthen monetary policy and reduce market
My question is this: What would we expect
to observe in speculative markets if monetary
policy were working “perfectly”? I do not mean
“perfectly” in some utopian sense, but within the
context of the world of incomplete information
in which we actually live. We know that policy
problems may arise when the central bank and
the markets have different information sets, or
have different perceptions about the state of the
economy or the direction of policy. My concept

of policy “perfection” is that the markets and the
central bank have the same information set,
incomplete though it may be. Information is
incomplete because the future is uncertain and
the discipline of economics is unsure about many
important relationships.
I’m deliberately using the word “perfect”
rather than the word “optimal” because I want
to avoid the implication that the subject at hand
is an optimal control issue, which would involve
such matters as a possible trade-off between
employment stability and price stability. I am
assuming that society has somehow made its
choices according to the objectives of monetary
policy and how they are to be pursued within
the constraints of how the economy works. The
terminology is a bit awkward; information is
inherently imperfect, but my topic concerns differences in information held by the central bank and
the markets. By policy “perfection,” I mean that
the differences in information have disappeared—
both the central bank and markets have the same
imperfect set of information. I’ll keep “perfection”
in quotation marks to help make clear that the
issue is the equality of imperfect information
between the central bank and the markets.
The assumption that monetary policy is
“perfect” implies certain things about how markets
should behave. I will concentrate on the behavior
of financial markets, and will take as givens the
policy goals so I can concentrate on the “perfection” of information between the markets and the
central bank. This topic is a large one; my purpose is to introduce my model, explain how this
model can help us understand how policy has


evolved, suggest ways in which departures from
“perfection” indicate problems with my underlying model and ways to improve policy. I’ll only
be able to touch upon a few of these areas.
Here are the key questions my analysis
addresses: Under a “perfect” monetary policy,
would we observe large market responses to policy
actions? And, would we observe large market
responses to innovations, or surprises, in economic data? I will argue that under a “perfect”
monetary policy, we should not expect to observe
any market reactions to Fed policy actions. Every
Fed policy action should be completely anticipated by the time it occurs, and therefore should
be a nonevent in the markets.
I’ll proceed by first listing a few examples of
dramatic policy changes that did have major
effects on market prices. Then I’ll briefly discuss
the efficient markets model that serves as the baseline explanation of price determination in speculative markets. Because my topic concerns the
interactions of the markets and the policymakers,
I’ll next discuss Federal Reserve objectives and
policy implementation. Putting the market and
Fed policy together, my claim is that policy “perfection” requires the Fed and the markets to react
the same way to arriving information. In this case,
the market and the Fed are in synch; the market
anticipates Fed policy actions and is not surprised
by them. Large changes in market prices to policy
actions obviously indicate market surprises. In
such cases, policy changes can sink the markets,
or send them into orbit.
Before proceeding, I want to emphasize that
the views I express here are mine and do not
necessarily reflect official positions of the Federal
Reserve System. I thank my colleagues at the
Federal Reserve Bank of St. Louis for their comments, while retaining full credit for errors.

Let’s start by examining a few dramatic examples of policy changes that reflected Federal

Reserve actions or had possible implications for
future Federal Reserve actions:
• Sunday, August 15, 1971. President Nixon
closed the gold window and announced
comprehensive wage and price controls.
The following day, the 20-year Treasury
bond yield fell by 18 basis points and the
Dow Jones Industrials rose by 3.8 percent.
• Saturday, October 6, 1979. The Federal
Reserve introduced a dramatic set of new
policies. When the markets reopened the
following Tuesday (Monday was the
Columbus Day holiday), the 30-year
Treasury bond yield rose by 25 basis points,
and the Dow Jones Industrials sank by 4.5
• Sunday, September 22, 1985. The G5 countries announced the Plaza Agreement,
which called for these countries to pursue
policies to depreciate the foreign exchange
value of the U.S. dollar. The trade-weighted
dollar index fell by 3.5 percent the next day,
the 30-year Treasury bond yield rose 6 basis
points, and the Dow Industrials rose 1.4
These three examples reflect dramatic policy
changes. I could offer hundreds of other smaller
and more routine examples. I have refrained
from listing examples of market responses to
nonpolicy information, such as the employment
report that arrives on the first Friday of every
month, but I am sure that everyone here is familiar—perhaps all too familiar—with such market
responses. Markets react to data releases in part
because of the belief that the central bank will
respond to the information.
What do we make of these market reactions
to both policy actions and data releases? From a
policy perspective, are these market responses
simply an unavoidable side effect of policy
actions? Should the monetary authorities attempt
to avoid large market reactions, or are the market
reactions an essential part of the process by which
monetary policy effects are transmitted to the

Synching, Not Sinking, the Markets

The efficient markets paradigm surely has to
be the starting point in understanding speculative
markets. According to this view, speculative
markets respond efficiently as market participants
assess all relevant information—absolutely everything that might influence market prices—and
bid market prices up or down accordingly. Given
that investors bid current prices to levels at which
risk-adjusted expected rates of return are equalized
across various investment alternatives, each new
piece of information may move market prices.
The efficient markets model is not perfect, but it
certainly goes far in explaining the behavior of
speculative prices.
So, markets respond to the flow of all sorts of
information, including that from the central bank.
Federal Reserve policy actions, and statements
by Federal Reserve officials—especially the
chairman—affect market expectations about the
future and, therefore, current market prices.
The information that matters, of course, is
new information. Everything predictable has
already been bid into market prices; only the
reports coming across the wires that change the
probabilities of future outcomes affect current
market prices. This point is well understood by
most market participants and most of the financial

Now I want to discuss the interactions of
speculative markets with monetary policy actions.
Market participants are trying to forecast the
future, and so they are naturally interested in what
the Fed is trying to do. Let me make the assumption—which I think is accurate, but will not argue
here—that the goal of the Federal Reserve is to
keep the rate of inflation low and steady, a goal
that I’ll call “price stability.” Also, insofar as
possible given the price stability goal, the Fed
wants its policy actions to contribute to the stability of employment and output. I believe that

price stability will, if anything, yield lower average
unemployment than will prevail at higher inflation. Price stability will contribute to maximum
sustainable economic growth.
So, the Fed’s primary goal is price stability
and its secondary goal is stability of output and
employment to the extent possible. However, my
argument does not depend on the specification
of the monetary policy goals—substitute your own
if you do not like my formulation. Of course, the
markets must assess not only the Fed’s goals, but
also its skill in achieving those goals. I also take
as given the policy procedures the Fed uses to
reach its goals. The point is that the Fed’s policy
goals and procedures are key pieces of information
to the markets because this knowledge helps
market participants predict how the Fed will
respond to new information.
How would we expect markets to behave if
Federal Reserve policy were “perfect?” If policy
were “perfect,” we would certainly not expect
the federal funds rate—the Fed’s short-run policy
instrument—to remain forever constant at an
unchanged level. The fed funds rate would have
to be higher sometimes and lower sometimes to
be consistent with the policy objectives. How
would the Fed decide when and by how much to
change the federal funds rate? Well, as new information arrived, the Fed would process that information to decide on adjustments of the federal
funds rate. FOMC members are constantly examining the flow of incoming information on the
state of the economy and working to decide what
policy actions may be necessary to keep the economy on the desired track.
Of course, FOMC members may have different
interpretations of the incoming flow of data and
the appropriate policy responses. The implications
for policy of a particular event are rarely perfectly
clear. The fact is that economics provides tremendous guidance, but does not provide calculations
out to the second decimal place. Indeed, sometimes even the appropriate direction of policy
action is unclear. Nevertheless, it is helpful to
think about policy this way: There is in principle
some correct policy response to each piece of


information that comes along, and that the aim
of the FOMC is to dial in that response at its next
meeting. The appropriate response, for example,
may be to keep the funds rate steady. Indeed, I am
convinced that one of the greatest benefits a high
degree of market confidence in the Fed affords is
the Fed’s ability to sit tight and wait until it’s quite
clear which Fed policy actions are appropriate.
Now let’s return to the market responses.
The markets and the Fed are both responding to
the same flow of information. At this point, let’s
assume that the markets and the Fed get the same
information at the same time—neither has an
informational advantage. It is easy to see the nature
of the expectational equilibrium. The markets and
the Fed have a common response to new information. The markets know the Fed’s policy objectives
and the policy adjustments that are appropriate
given each piece of new information. The FOMC
meets every six weeks, but by the time of each
meeting, the markets know full well what policy
adjustment, if any, is necessary and desirable.
The Fed adjusts policy according to the market
forecast, and no one is surprised. Fed action is a
nonevent in the markets.
The predictability of Fed policy actions under
these conditions is the central insight of the
analysis. Given that the FOMC acts as the market
forecasts, the FOMC’s actions are not themselves
information and therefore elicit no adjustment of
market prices. Those adjustments have already
taken place during the period between FOMC
meetings as the markets respond to the steady
flow of new information in the form of the employment report, housing starts, productivity, employment cost index, etc., etc., etc.

This idealized picture of the markets and the
Fed responding the same way to the same data is,
I believe, the model we should all be striving to
achieve. We want price stability precisely because
we believe that avoiding inflation surprises adds
to the efficiency of the market economy and pro4

motes maximum sustainable economic growth.
We cannot hope or expect to avoid all surprises,
for the nature of our world is that the future is
unpredictable. These unpredictable events include
natural disturbances, such as earthquakes and
floods, political disturbances at home and abroad,
many changes in tastes and technology, and so
forth and so on. Markets respond efficiently to
these disturbances most of the time. Our aim is
for monetary policy to offset shocks, when possible, to prevent them from pushing the economy
away from price stability. Of course, we also want
to avoid introducing monetary policy disturbances
per se that adversely affect price stability.
The job of the central bank is to maintain a
clear focus on price stability and to convey that
focus to the markets. The central bank and the
markets can then respond in identical fashion to
the flow of incoming information, reaching the
same conclusions as to implications of the information for monetary policy adjustments. In this
model, the markets are not taken by surprise by
policy actions, for they have already figured out
what needs to be done.
I think this idealized picture takes us a long
way toward understanding how monetary policy
and the markets should interact when policy is on
a successful track. In this environment, the Fed
and the markets are synched. With complete synchronization, the markets and the Fed have a common understanding of the objectives of monetary
policy and a common interpretation of the significance of each piece of incoming information.
Suppose the federal funds futures market does,
in fact, accurately forecast decisions at FOMC
meetings. Is that an indication that the Fed is
simply following the markets, and not exercising
its proper leadership role? Obviously, I think not.
Market prices that anticipate what the FOMC is
going to do are not only consistent with policy
“perfection,” in the sense that I have been discussing, but also actually necessary for policy
“perfection.” Regularity and predictability are
important policy goals. Market success in anticipating FOMC actions indicates Fed success in
designing policies to achieve goals society accepts,
and in conveying those policies to the public. I

Synching, Not Sinking, the Markets

put the point this way because no central bank
in a democratic country can long pursue goals
not accepted by the society at large. The markets
and the Fed cannot converge on a common understanding of the direction of monetary policy if
the Fed does not pursue its goals in a consistent
fashion over time.
What do we make of cases in which Fed policy
actions create large market responses? Clearly,
policymakers can sink the markets, or send them
into orbit, when a surprise policy action boosts
market prices. Changes in policy direction are not
necessarily undesirable; policy ought to change
if it has drifted off course. That, I believe, was the
case with the 1979 change in Fed policy. What is
unfortunate about such a case, however, is that
policy drifts off course in the first place. Sinking,
or orbiting, the markets certainly can reflect some
sort of policy failure, either because an undesirable policy is being corrected or because policy is
taking off in an unforeseen and undesirable direction. I believe that the 1971 policy turn toward
comprehensive wage and price controls was an
example of policy taking a wrong turn. I include
this case in my list of examples because the introduction of wage and price controls did have
monetary policy implications; many observers
thought the controls would take care of inflation
and permit monetary policy both to be more
expansionary and drive down unemployment.
Sinking may also reflect some sort of market
error. I have deep respect for market judgments
but do not believe that they are invariably correct.
Sometimes markets wake up to errors, and prices
adjust rapidly. Very little is known about this subject, but the 1987 stock market crash is certainly
an example of a market error. Either the crash
was an error, the market advance prior to the
crash was an error, or both were errors. No economic data or policy changes arrived at the time
of the crash to justify an adjustment that large.
In any event, the key point remains. A large
market response to a Fed policy action is evidence
that the markets and the Fed are not in synch.
Either the market or the Fed, or both, must have
been operating on the basis of different information, which may include different assessments

of the significance of readily observable data. The
more complete the convergence of views between
the market and the Fed, the better the economy
will work. Convergence reduces market volatility and expectational errors, which can lead to
resource misallocation. Firms, for example, may
make investments that prove to be unprofitable
because their expectations were wrong.
The Fed has not reached the point that its
policy actions elicit zero response in the markets.
But let me offer a hypothesis, which I have not
yet investigated but hope to be able to. Everyone
agrees that, in recent years, economic outcomes—
in terms of both inflation and unemployment—
have been better than in the past. My hypothesis
is that monetary policy has been more regular and
predictable than it used to be. This hypothesis
can be tested by examining whether Fed policy
actions account for a smaller fraction of the variance of interest rate changes in recent years than
in the past. Put the other way around, my hypothesis is that nonpolicy events, such as data releases,
account for a larger fraction of total interest rate
variance now than they did in the past.
My model of synching the markets and policy
is incomplete in some important respects. Two
issues particularly concern me.
First, the pure version of the model requires
that the Fed and the markets have the same information about the economy. I think that, relative
to the markets, the Fed actually has superior
information in some cases and inferior information in other cases. What is clear is that full synchronization with the markets requires that the
Fed pay careful attention to both collecting and
conveying information. Transparency and clarity
are necessary ingredients for policy success.
Second, there are considerable differences in
professional opinion about how the economy
works. The debates inside the Fed and outside
the Fed are similar. The markets and the Fed will
never be completely in synch because there will
always be something for economists to argue
about, and the Fed and the markets will not necessarily come to the same judgments. Still, it is
important not to lose sight of the fact that there
is an enormous common base of understanding


between the Fed and the markets, and that this
common base has a lot to do with policy success.

I’ll close by re-emphasizing my main theme.
When the markets and the Fed are in synch, both
will have a common reaction to incoming data,
and the markets will correctly anticipate Fed
policy actions. An environment in which markets
correctly anticipate Fed actions implies a situation
in which Fed policy is widely understood, regular,
and predictable. The fact that Fed policy actions
sometimes take the markets by surprise shows
that we have not reached “perfection” yet.
Still, it is important to recognize that the Fed
has made tremendous progress over the last 20
years or so in pursuing a consistent policy
designed to establish price stability as the norm
for the economy. The Fed and the markets are
mostly in synch; surprises in the incoming data—
whether on prices, employment, GDP, activity in
economies abroad, and so forth—are surprises to
both markets and the Fed and both read the surprises pretty much the same way. If the market
and Fed readings become identical, we can expect
that Fed policy adjustments will convey no new
information to the market, and therefore market


prices will not respond to them because they are
fully anticipated.
I believe that a policy agenda designed to
heighten the degree to which the Fed and the
markets are in synch is an ambitious and worthy
objective. We in the Fed need to work on two
fronts, in my opinion. One is the policy front
itself, making sure that policy actions are as
appropriately timed and scaled as possible. The
second is on the disclosure front, making sure that
knowledge inside and outside the Fed converges
to the maximum possible extent.
Progress on both fronts will require continuing research. It is clear to me that new insights into
the convergence, or lack thereof, of information
between markets and the Fed will play a central
role in this research. My insight today is completely consistent with—indeed is implied by—
rational expectations macro models. What I had
not done before in my own mind is relate these
abstract models to the daily ebb and flow of market reactions to new information. The conclusion
I have been discussing—that, with full convergence of information, Fed policy actions will not
affect market prices because the market has
already predicted them—initially surprised me.
But the more I think about the matter, the more
compelling the conclusion is. I hope you agree.