hen the Fed and the markets are out of synch, policy actions taken by the Federal Open Market Committee can generate large market responses. These market responses reflect errors in expectations of policy moves, which can lead to resource misallocation by individuals and businesses alike. But while changes in policy direction are not necessarily undesirable--policy ought to change if it has drifted off course--large fluctuations in market prices following policy actions indicate that the markets and the Fed are not operating on the same page. A lack of synchronicity can be due to one of three factors: either the market and the Fed are operating on the basis of different information, they have different views about what the information means, or they have different views about the policy objectives.

DIFFERENT INFORMATION

The reality is that the markets and the Fed do not have exactly the same information. While informational differences are minor, they do exist. In individual markets, the participants themselves often have more complete and timely information than the Federal Reserve does. The Fed attempts to compensate for its market-by-market disadvantage by carefully analyzing statistical information and by collecting as much anecdotal information about markets as possible through its contacts with business and labor leaders, financial analysts and many others.

When it comes to aggregate information, however, the Federal Reserve likely has some informational advantage over market participants. The Federal Reserve is one of the largest and most skillful data collection and processing organizations in the world. While everyone receives the raw data--such as the employment report--at about the same time, the Fed's army of economists is no doubt able to extract additional information from the available data. What is the implication of the Fed's informational advantage on big-picture data? The Fed will sometimes act or not act on the basis of this advantage, taking the markets by surprise. Such cases probably explain many routine, relatively small, market reactions to FOMC policy actions. The bottom line on information about the economy is that differences in the market's and the Fed's information sets do exist, but they are a minor issue.

DIFFERENT VIEWS ABOUT WHAT THE INFORMATION MEANS

Another way the markets and the Fed can be out of step is in how they interpret the same information. For example, suppose that the Fed thinks economic conditions are softening and that lower interest rates are appropriate. Believing that only modest stimulus is required, the Fed lowers the intended, or target, federal funds rate by one-quarter of a percentage point. The market, however, might conclude that the cut is the first of several. Based on this belief, the market bids longer-term rates, including the mortgage rate, down by, say, half of a percentage point. The Fed finds that the stimulus to economic activity is greater than intended, and, in a few months, it reverses the original rate cut. Longer-term interest rates rise, and the market is thoroughly confused about the Fed's intentions.

Again, purely hypothetically, assume the market interprets the Fed's initial cut in the intended fed funds rate as temporary. In this case, longer-term rates move little, if at all. The Fed discovers that It has not provided enough stimulus to the economy and, in a few months, cuts the federal funds rate again. Longer-term interest rates eventually fall, but valuable months have been lost. In both examples, the lack of synchronicity between the markets and the Fed has resulted in inefficiencies that adversely affect the economy.

DIFFERENT VIEWS ABOUT POLICY OBJECTIVES

A final way the markets and the Fed can be out of synch is in the different views they have about the prevailing policy objectives. This confusion occurs in one of three areas: in the Fed's objectives for inflation, in its objectives for economic growth or in its perceptions of the interplay between the two.

When it comes to inflation, the Fed has the ability to choose an objective from a wide range of options, including alternative indexes and alternative time frames. Confusion may arise, however, because the Fed does not have a specific inflation objective. The objective is that inflation should be low and steady, but market participants are left guessing as to exactly what level or range the Fed regards as acceptable at a given point in time.

When it comes to economic growth, however, the Fed is unable to set a specific objective--say, 3 percent. Here, the Fed can only attempt to keep output near its potential. The growth of potential is determined by labor force growth and productivity growth, both of which are beyond the Fed's control. Because potential growth is not a Fed target, it is probably not wise for the Fed to emphasize a specific numerical estimate of potential growth. Indeed, different policy-makers have different estimates of potential growth. Nevertheless, Fed officials have helped to strengthen public understanding of these important issues by offering analyses of employment and productivity growth.

Uncertainty about which of the Fed's objectives--inflation or economic growth--is most important at any given time adds to the confusion about policy objectives. For example, if output grows more rapidly than expected--as we've seen during the last four years--the public cannot be sure whether the Fed will raise the fed funds target to prevent inflation or whether the Fed will raise its forecast of the growth in Gross Domestic Product (GDP). In 1999, the Fed both acknowledged the increase in labor productivity growth--suggesting that perhaps the FOMC's output objective had been raised--and raised the fed funds rate target.

In any of the three cases, the lack of clarity about policy objectives can lead to inefficiency and a lack of synchronicity.

Our current system, then, is characterized by incomplete synchronization of the Fed and the markets. The incompleteness reflects, to a small degree, differences in information. Different interpretations of information and different views on policy objectives are more important. The next section of this report describes the St. Louis Fed's proposal for addressing both of these reasons for incomplete synchronization.