Commentary on "Efficient Inflation Targets for Distorted Dynamic Economies

Keynes (1936) was right to emphasize that the investors' expectations have a paramount effect on the evolution of the national economy. Indeed, an impor­ tant part of the role of the financial services sector in a modern economy is to try to forecast how the central bank will react to macroeconomic shocks, and any Wall Street economist worth his or her salt has a rule of thumb-a model drawn perhaps from some collective economic unconscious-that predicts how the Federal Open Market Committee will react to a bad inflation number or to a high unemployment figure. The high priest of the caste of economic forecasters-the Carl lung of Wall Street economists-is John Taylor, whose elegant description (1993) of the Fed's putative policy rule has become a workhorse for modern macroeconomic analysis. The essence of a simple version of Taylor's rule is that the Fed should raise nominal interest rates sharply if there is bad inflation news. This is the crux of how the Fed builds "credibility" in financial markets. Whenever there is a bad inflation number, the market is faced with a quandary: Is this a sign that the Fed is loosening monetary policy, or is it a signal that the Fed will tighten future interest rates to cool down a national economy that is perhaps over­ heated? Once investors have assimilated Taylor's "activist" policy rule, the market will react to an inflation shock assuming (correctly) that the Federal Open Market Committee is serious about maintaining low inflation. An important added benefit is that the Fed itself will know how the market will react to rising nominal interest rates, and this knowledge cuts through the Gordian knot of higher-order expectations that Keynes first described in his famous passage on financial markets as beauty contests in chapter 12 of The General Theory. The Fed no longer needs to guess how investors will act in response to their own forecasts of the Fed's prediction of how private markets will divine the latest news about how a member of the Federal Open Market Committee might react to her staff's using the newest (public) inflation number to make a forecast of the national economy in the next quarter! The right kind of Taylor rule makes it easier for the central bank to maintain both low inflation and full employment because there is a built-in stability in market expectations.! This observation is the essence of the …