The Federal Reserve Bank of St. Louis 1999 Annual Report

Synchronize

Cause to occur at the same time or rate of speed

The theme of this year's annual report suggests an ambitious goal: to better synchronize the Federal Reserve and the financial markets. Just as trapeze artists display a mastery of timing and communication to achieve an outstanding acrobatic feat, the Fed and financial markets could use similar skills to achieve an outstanding economic feat. What would such a feat require? Ideally, that the Fed and the financial markets receive the same information at the same time and interpret it the same way. The first part is easy. For all practical purposes, the markets and the Fed do receive the same data at the same time. Developing a common interpretation, though, is not so easy.

The impact of such a synchronization would be significant. The print, broadcast and electronic media speculation that occurs before each meeting of the Federal Open Market Committee (FOMC) would become less intense. The media would concentrate on interpreting the data, rather than on interpreting the Fed.

The decreased news coverage would, however, be the least important consequence of a synchronized financial system. Most important would be the impact that closer synchronization would have on businesses and households. The markets and the Fed would both concentrate on the difficult task of understanding the flow of information, with all its inherent uncertainties and ambiguities. Because of the difficulty of this task, the Fed's and the markets' interpretations would not always be correct, but they would be close to one another. Businesses and households, therefore, would not make mistakes because of their misunderstanding of the Fed's intentions and interpretations.

In this report, we'll first take stock of the inefficiencies that arise in the present day when the Fed and the markets are operating on different wavelengths. We'll then consider what we at the St. Louis Fed believe can be done to bring about greater synchronicity with financial markets. Finally, we'll look at some of the steps that are already under way to improve synchronicity.

This report was adapted from two speeches delivered by William Poole: "Synching, Not Sinking, the Markets" and "Communicating the Stance of Monetary Policy." The opinions expressed here are not necessarily those of the Federal Reserve System.

President's Message

William Poole, President and CEO, Federal Reserve Bank of St. Louis

This year's annual report highlights the need for greater synchronicity between the Federal Reserve and financial markets. By greater synchronicity, I mean a greater understanding of each other's expectations, interpretations and actions. The Fed has long had a large staff devoted to deepening its understanding of how markets are likely to respond to monetary policy actions, or lack thereof. Over time, the Fed has also increasingly recognized how important it is that the markets understand how monetary policy is conducted. After all, for the Fed to understand the market, the Fed must also understand the market's expectations about monetary policy. Clearly, both the market and the Fed have a problem if the market's expectations do not match the Fed's intentions.

All the attention to the stance of monetary policy is perfectly understandable: There's an awful lot of money at stake in today's financial marketplace. There is, therefore, an intense--and completely proper--public interest in correctly understanding the monetary policy-making process. And since the ones who know the most are the ones most directly involved in this process, policy-makers like myself often find people hanging on our every word. We policy-makers are the ones responsible for providing as much information as we can. In fact, what is at stake is more a matter of knowledge than of information. The public needs to understand how and why policy is made, and not just the specifics of particular policy actions.

While I'm all for the increased communication that greater synchronicity demands, there are limits to what FOMC members can say. Political accountability and economic efficiency require that the FOMC disclose as much as possible without damaging the integrity of the decision-making process upon which sound policy depends. If, for example, FOMC meetings were broadcast live on C-SPAN, the entire nature of the policy deliberations would be changed. Some critically important issues could not be discussed freely and openly, and others would not be raised at all. While the FOMC's deliberations can't be found on cable TV, they are available to the public in transcript form, with a lag of about five years.

The goal for us at the Fed is, I believe, to strike a balance--to communicate as much as we are able as clearly as we can without sacrificing the candor and completeness that policy-making discussions require. A daunting task, to be sure, but one that's worthy of our best attempt. This report is dedicated to that goal.

Our Current, Imperfect System

Different views and different interpretations are the biggest obstacles

When 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.

 

Inside An FOMC Meeting The focal point of every FOMC meeting is the final vote on the intended federal funds rate target, which occurs at the meeting's end. To reach this decision, committee members hear staff briefings, examine data that have arrived since the last meeting and deliberate about the appropriate monetary policy stance. Before every FOMC meeting, Board staff and Reserve Bank staff brief the governors and Bank presidents on economic news since the last meeting. These briefings differ among Reserve Banks, depending on each bank's traditions and each bank president's background. Every briefing, however, includes a discussion of what the incoming news implies for the monetary policy stance. The Board staff prepares and circulates regular briefings and, before each FOMC meeting, the Greenbook and the Bluebook. The Greenbook contains the economic forecast for the next year or two; the Bluebook includes a summary of open market operations and financial market developments, as well as a discussion of policy options. FOMC meetings usually begin at 9 a.m. on a Tuesday morning with presentations to the committee from the international and open market desks at the New York Fed. After a discussion period, Board staff members present the key elements in the Greenbook forecast. Committee members then offer their views about the state of the economy and whether they think the incoming news has shifted their opinions about the appropriate monetary policy stance. Of course, FOMC members may have different interpretations of the incoming data flow and the appropriate policy responses. In fact, the policy implications of a particular event are rarely perfectly clear. Although economic theory provides tremendous guidance, it does not provide calculations out to the second decimal place. Indeed, sometimes even the appropriate direction of policy action is unclear. Nevertheless, it is insightful to think about policy as if there is some correct policy response to each new piece of information that comes along, and that the aim of the central bank is to dial in that response in a timely fashion. After this first discussion round, a staff member who helped prepare the Bluebook provides a briefing on financial markets, the monetary aggregates and policy options. Committee members then state their views about the policy stance in a second go-around. The committee often discusses at length what to say publicly about the probable, or possible, future policy direction. The aim is always to determine the most constructive thing to say to make policy more effective and not to confuse--even inadvertently--the markets. Finally, a vote is taken on the key decision: the fed funds rate target. Under normal circumstances--meaning that there are no special factors upsetting financial markets--the committee faces four types of situations, reflecting different combinations of inflation and economic outcomes. Suppose that both inflation and output have come in above expectations and are projected to continue that way over the short term. In such a situation, no one will be calling for a lower fed funds rate target. But even in this case, members will differ in their projections and the certainty with which they are held, so typically there will be some sentiment for raising the target and some for awaiting further developments. The case in which both inflation and real growth have come in below expectations is parallel: No one will want to raise the target. The discussion will revolve around whether to lower the fed funds rate target at the meeting, or wait for further information. The difficult cases are those in which inflation comes in above expectations, while output comes in below, or vice versa. If such situations go on for a long time, it is usually because economists have misjudged the economy's underlying growth potential. In the 1990s, for example, inflation has, on average, come in below expectations, while the real economy has surprised almost everyone on the upside.

The gains to the economy of a sustained Fed policy to foster low inflation are manifest. The task remaining is for the Fed to make its inflation objective more precise.

A Call to Action

Closer synchronization may be just an objective away

One important step the Fed could take in promoting greater synchronicity between itself and the markets is to clarify its long-term policy objective. Although there has been a growing consensus that price stability--a low and steady inflation rate--is the primary goal of monetary policy, the objective remains rather vaguely defined. The Fed also--as much as possible given the price stability goal--acts to stabilize the employment and output levels. While these goals may appear to be conflicting at a particular moment in time, experience and developments in macroeconomic theory have taught us that the trade-off between employment and inflation is temporary at best. Indeed, attempts to lower unemployment by allowing inflation to rise have backfired.

Recent research at the Federal Reserve Bank of St. Louis shows that, even if there were a short-run trade-off between inflation and output, the adoption of an operational goal for long-term price stability would enhance the FOMC's ability to stabilize these measures.

What do we mean by an operational goal for long-term price stability? We mean choosing a specific number or a narrow range for a particular price index. An explicit multi-year objective would provide a benchmark that would help put the current policy situation in a longer-term perspective. This is quite unlike the current situation in which each FOMC member has an individual view about the operational definition of price stability. There is no overall objective that has been adopted to represent the consensus view. For example, some members may define price stability as 0 percent inflation, based on the GDP chain price index, some may define it is as 2 percent inflation in the Consumer Price Index (CPI), and still others may not have a precisely defined view. Also, members are likely to differ in their assessments about the probability of rising inflation or a recession. Individual members form their own views of the objectives and the current state of the economy when deciding how to vote at FOMC meetings. The nature of the committee process means that the FOMC's objectives--as a body--are not clearly defined. Furthermore, changes in the makeup of the committee can lead to subtle changes in the actual monetary policy objectives.

To see why clarification of the long-term objective is important for bringing about improved synchronicity, consider the information problem that the market would have to solve when the policy objective is explicit and policy is "perfect." Policy would be perfect if the markets and the Fed had a common understanding of three things: the monetary policy objectives, the interpretation of new information and the policy actions required to achieve the objectives in light of the new information. In these circumstances, securities prices, for example, would respond to the new information itself and not to the Fed's policy decisions. Each policy decision would be an implication of the new information. New information on the state of the economy is inherently unpredictable and, therefore, naturally takes the markets by surprise. Some surprises would be larger; most would be small. But, ideally, Fed policy actions would not be surprises at all; given the new information, the market would know what policy action to expect.

Even if perfect policy existed, we would still have much disagreement about how the world works. Markets would not know for sure how a given piece of news would affect the short-run path of inflation, or whether it would trigger a change in the Fed's policy stance. Opinions about these short-run matters would differ, but markets would know the long-term price objective, and the objective would not change because of that news, or the Fed's short-term reaction to it.

Now suppose that the price stability objective is vaguely stated, as it is now. Market participants do not know whether price stability means 3 percent inflation in the CPI, as we experienced from 1991 to 1996, 2 percent inflation as we have seen over the last three years, or 0 percent inflation--after allowing for measurement errors in price indexes--as representatives of this bank have recommended. Without a precise long-term objective, markets not only have to figure out how incoming information affects the short-run inflation path and the probability of future FOMC policy actions, they also must decide how all of this will affect the long-term objective.

If people believe the Fed is committed to price stability, market interest rates would do much of the stabilization work. If the public truly believes that the Fed would do whatever is necessary to achieve its long-run objective in response to a potentially inflationary shock, the Fed may not have to do anything or, at least, not anything quickly. During 1996, for example, news about economic performance and inflation exceeded market participants' expectations. Such a change in economic conditions would normally require an increase in the fed funds rate target. But even though the FOMC did not raise the fed funds rate target in 1996, the interest rate on one-year Treasury bills rose a full percentage point in the first half of the year. Although the strong economic growth has continued into 2000, the 1996 increase in inflation proved to be only temporary.

If the price stability objective were more specific and credible, the Fed would also not have to raise the fed funds rate target as much to lower inflation expectations. What the Fed would have to do with the target to achieve its inflation objective depends both on how strongly people believe the Fed is committed to price stability and on what sort of economic disturbances occur. Economic disturbances, such as droughts and oil price shocks, will cause temporary fluctuations in price indexes. Policy-makers cannot prevent such fluctuations, nor should they want to. What they should do is prevent these temporary events from changing people's longer-term inflation expectations. Like the physician whose first responsibility is to do no harm, the FOMC should avoid destabilizing the economy by allowing erratic changes in expected inflation. Although the Fed does not have direct control over month-to-month changes in the inflation rate, it could help stabilize and synchronize the process by choosing a long-run inflation target.

A central bank that has credibility in maintaining long-term price stability also has more flexibility in dealing with short-term problems, such as financial crises and recessions. Credibility is an asset that pays high dividends. When the Fed--responding to financial disruptions following the crisis in the Russian bond market--lowered the fed funds target in the fall of 1998, the markets' expectations of continued low inflation remained rock solid. In another era, the Fed might not have lowered the fed funds target in such a situation for fear that many might have interpreted the action as an indication that the Fed was softening its resolve to control inflation. Low inflation and high credibility enhance the Fed's range of options in taking policy actions in the face of unusual circumstances.

The gains to the economy of a sustained Fed policy to foster low inflation are manifest. The task remaining is for the Fed to make its inflation objective more precise.

 

The Fed Funds Futures Market: Synched with the FOMC? No one, including the Fed, knows what market interest rates will be. In the face of such inherent uncertainly, markets have emerged. One of these is the federal funds futures market. Federal funds futures are contracts traded on the Chicago Board of Trade. The dollar amounts traded are large--the trading unit is $5 million. All contracts mature on the last business day of a future month. The price at which a contract trades depends on market participants' expectations of the daily average federal funds rate in the maturity month. The higher the funds rate at maturity, the lower the final value of the contract. Before maturity, the contract price fluctuates as market participants receive new information. Purchased contracts can only be closed out prior to maturity by selling an offsetting contract of equal trading units and maturity at the prevailing market price of the contract, and vice versa. The market rate for fed funds futures incorporates market participants' estimate of future FOMC policy decisions. At each FOMC meeting, the committee issues a directive, which specifies a target for the federal funds rate, to the New York Fed's open market desk. The "Desk" then conducts open market operations--buys and sells government securities--to keep the actual federal funds rate in close proximity to the target rate established by the FOMC. The Desk is generally quite skilled at minimizing the differences between the actual federal funds rate and the target specified by the FOMC. In fact, on a monthly average basis, the actual fed funds rate is very close to the target set by the FOMC. Thus, the price at which federal funds futures trade reflects market participants' best guess as to what the FOMC will do with the federal funds rate target in future months. Market participants sometimes anticipate the FOMC's action on the fed funds target correctly, and sometimes not. An example of the latter occurred in July 1992. At its July 1, 1992, meeting, the FOMC announced that it reduced the federal funds rate target from 3.75 percent to 3.25 percent. Before the meeting, the August funds rate futures contract traded somewhat below the old target level of 3.75 percent. As the top chart shows, when the change in the target was announced, the yield on the July futures contract quickly dropped down near the new target level. In this case, it appears that the change in the fed funds target was not widely anticipated, taking market participants by surprise. At other times, however, the market is dead-on in its anticipation of FOMC actions. In August 1994, for example, market participants appeared to anticipate the FOMC decision well in advance of the committee's meeting. At the Aug. 16, 1994, meeting, the FOMC announced that it increased the fed funds rate target from 4.25 to 4.75 percent. Before the meeting, the September funds rate futures contract traded slightly below the new target level of 4.75 percent. As the bottom chart shows, when the change in the target was announced, the yield on the September futures contract changed only slightly. In this case, it appears that the change in the target was widely anticipated as early as mid-July, and market participants were not surprised by the FOMC's action. If the Fed and the markets were better synchronized, we'd see participants in the fed funds futures market make successful predictions like this more often than not.

Like the physician whose first responsibility is to do no harm, the FOMC should avoid destabilizing the economy by allowing erratic changes in expected inflation.

Getting In Synch

It may not be easy, but we're already part-way there

Without clear objectives, the task of getting the markets and the Fed in synch is enormously difficult, especially since so many different considerations have to be folded into policy decisions. For example, at any given time, there might be six important considerations that point toward policy easing and four that point toward policy tightening. The FOMC must weigh competing considerations, account for data inaccuracies and determine whether markets have already responded to the flow of information, making a Fed response unnecessary.

That said, the markets and the Fed have made great progress in recent years toward synchronicity. Market participants increasingly possess a deep understanding of monetary policy. In fact, much of the time, the Fed and the markets are in close agreement about what policy actions are required to keep the economy on a steady course. Fed policy-makers and market participants also use similar theories and data to form their short-term expectations. So, incoming information about the economy that surprises markets will typically surprise the FOMC, as well.

The track record of FOMC actions also helps put the markets on the same page with the Fed. So, too, does the FOMC's release of information. Since February 1994, the FOMC has announced changes in the fed funds target the same day that the decisions were made. Six or seven weeks later--a few days after the next scheduled meeting--the FOMC then releases the minutes of the previous meeting. These minutes reveal the topics discussed, summarize views about the state of the economy and describe the reasons for dissenting votes. The minutes are thorough, which provides an important vehicle for keeping the markets and the public well-informed about Fed thinking.

Through congressional testimony, speeches, articles in Fed publications and other ways, Fed officials make every effort to keep the public informed. Although it is commonplace to joke about Fed vagueness, the information flow is, in fact, substantial. Much of this vagueness is inherent in the difficulties of dealing with imperfect information. The accuracy of Fed economic forecasts, for example, is limited by the same lack of knowledge in the discipline of economics that affects everyone else's forecasts.

In the Fed, and certainly in this Reserve Bank, interest in disclosure issues is high. While these issues are not simple, Fed officials are thinking actively about disclosure issues and are fully aware of their importance in helping to bring about greater synchronization with the markets.

What would we expect to see if disclosure and market understanding were so complete that the Federal Reserve and the markets were synchronized? The price level would be stable, and the unemployment rate and real GDP growth rate would be relatively stable. We would certainly not expect, however, the federal funds rate 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 target? Federal Reserve staff and FOMC members are continually examining the flow of incoming information on the state of the economy and working to decide which policy actions may be necessary to keep the economy on the desired track. After processing the information, the FOMC would take the appropriate policy action at its next meeting. The market, sharing the Fed's analysis, would not be surprised by the policy decision, whatever it might be.

WHEN IT'S OK TO BE A FOLLOWER

In recent history, it often seems that the Fed is merely ratifying market expectations. Some observers cite this "following" behavior as evidence that the Fed is not exercising proper leadership. On the contrary, the market should be able to predict what the Fed is going to do; the St. Louis Bank believes this synchronicity is what the Fed should be striving for. If monetary policy is to be fully successful, markets must understand the Fed's goals and the procedures used to achieve them. When monetary policy has been successful for an extended period, it should disappear from the headlines. Although the market has gained confidence in the Fed to keep inflation low and steady, we believe more can be done: The Fed should be more explicit about its inflation objective.

Everyone should understand that interest rates will not be perfectly stable if the Fed is successful in achieving its goal of low and stable inflation. Market interest rates have fluctuated substantially in recent years, despite the fact that inflation has changed little. As economic news arrives, the Fed must process the information and make the appropriate adjustments to the federal funds rate target. The better the market understands how and why the Fed reaches its decisions, the better it will be able to respond to new information in the same way the Fed responds to the information. The result will be a smoother, and more efficient, transmission of monetary policy changes to the economy's product, labor and capital markets.

Suppose markets do, in fact, accurately forecast decisions at FOMC meetings. Is that an indication that the Fed is simply following markets and not exercising its proper leadership role? Obviously, this is not the case. Market success in anticipating FOMC actions indicates Fed success both in designing policies that achieve socially acceptable goals and in communicating those goals to the public. The ideal environment is one in which the Fed and the markets are perfectly synchronized.

We at the St. Louis Fed are convinced that continued progress in achieving greater synchronicity will make a major contribution to ending the scourges of inflation and inflation uncertainty, of unstable booms and damaging busts.

 

Policy Failures: When the Fed and the Markets Were Not in Synch The rise of inflation in the post-World War II period is one of the most dramatic examples of monetary policy failure in U.S. history. Policy-makers allowed inflation to accelerate to such a high rate that polls of U.S. voters showed inflation to be the No. 1 problem in the country. Throughout the 1960s and 1970s, Fed policy-makers and other government leaders said they were fighting inflation, yet inflation grew higher with each business cycle. During the 1960s, there was a long-term rise in both inflation and market interest rates: Inflation rose from under 2 percent to about 5 percent, while the one-year Treasury bill rate rose from about 3 percent to 8 percent. The accompanying chart shows the expected real rate of return and the actual real rate of return on an investment in a one-year Treasury bill. Such "real" interest rates are a measure of market interest rates, adjusted for inflation. When the expected real rate of return is greater than the actual real rate of return, borrowers benefit at the expense of lenders, and vice versa. As the chart shows, real interest rates during the '60s were rather low, but generally positive. In August 1971, the U.S. government adopted a comprehensive package of wage and price controls in an attempt to stem the rising tide of inflation. The markets no doubt expected the Fed to go along with the program. The Fed, however, allowed rapid money growth to continue. While the price controls caused a temporary lull in the reported inflation rate, by 1973, severe shortages in many markets brought both an end to most controls and a rapid acceleration of inflation. As the chart shows, real interest rates actually became negative for much of the 1970s. People clearly did not expect inflation to be this high. In both 1977 and 1978, those who invested in Treasury securities lost money after adjusting for inflation. Those who borrowed money when interest rates were low--as in the '60s--and repaid their loans with inflated dollars made out like bandits. Lenders took the hit. Clearly, the market and the Fed were not in synch; market participants did not know the Fed was going to allow inflation to rise above 13 percent in 1979. On Oct. 6, 1979, the Fed announced the beginning of a new resolve to reduce inflation. But the market did not believe it. Interest rates remained very high despite the sharp fall in inflation--from about 13 percent in 1979 to about 4 percent in 1983. Because financial markets were skeptical that the Fed really would keep inflation low, real interest rates remained high, compared with historical averages, until the early 1990s. Investors who loaned money in 1980 did very well because inflation did not erode the value of their principal as they had expected it would. Those who borrowed money in 1980 were dismayed to find very high real debt burdens. Overall, everyone lost during the period from the '60s through the '80s. The gains made during one decade were generally offset by the losses in another, and vice versa. And the lack of Fed synchronicity with the markets was partially responsible.

The better the market understands how and why the Fed reaches its decisions, the better it will be able to respond to new information in the same way the Fed responds to the information.

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