Expectations show up in almost all modern business cycle models. However, the question is “whose expectations” Via Calculated Risk Fed Governor Walsh muses:

In my view, any judgment to expand the balance sheet further should be subject to strict scrutiny. I would want to be convinced that the incremental macroeconomic benefits outweighed any costs owing to erosion of market functioning, perceptions of monetizing indebtedness, crowding-out of private buyers, or loss of central bank credibility. The Fed’s institutional credibility is its most valuable asset, far more consequential to macroeconomic performance than its holdings of long-term Treasury securities or agency securities. That credibility could be meaningfully undermined if we were to take actions that were unlikely to yield clear and significant benefits.

The governor is clearly saying that he is worried about expectations of loose monetary policy. If it appears that the Fed is simply moving to alleviate short term concerns without paying attention to its long term mandate then it will loose its grip on the markets.

There is also no doubt that expectations of loose monetary policy exists. Pundits have been bleating about them for since the recession began. Should we be listening.

I’ve answered before: No

But, I want to be more formal about it so I am introducing two formal notions.

The Weak Price-Expectations Hypothesis: Any macro-economically relevant expectations can be captured in price data. That is, if an expectation matters then either a market exists or a futures market can be created which will capture all relevant information.

The idea is that if information is important to people they will be willing to trade on it. Information that no one will trade on is information that will not affect their choices and hence has no macroeconomic relevance.

The Strong Price-Expectations Hypothesis: Any macro-economically relevant expectations are captured in price data.  In other words, prices are the transmission mechanism of expectations. If there is no price that moves when a given expectation moves then that expectation cannot affect the macro-economy.

I write these down in part to clarify my own thinking. Implicitly I believe I have been working from the Strong PEH, but I may be willing to back down to the Weak PEH.

In either case the conclusion is that the Federal Reserve need not concern itself with causal observations of expectations in the media or elsewhere. In the strong version there must be a price someone can point to. In the weak version information may be missing but the optimal solution will always be to create a futures market for that information.

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