Let a Thousand Models Bloom the Advantages of Making the FOMC a Truly 'Open Market

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Contributions to Macroeconomics

Volume 6, Issue 1 2006 Article 8

Let a Thousand Models Bloom: The

Advantages of Making the FOMC a Truly

‘Open Market’

Scott Sumner∗

∗Bentley College, [email protected]

Copyright c2006 The Berkeley Electronic Press. All rights reserved.



Let a Thousand Models Bloom: The

Advantages of Making the FOMC a Truly

‘Open Market’∗

Scott Sumner

Abstract

In recent decades there has been a worldwide shift toward market-oriented economic policies,

sometimes termed ‘neoliberalism’. In the policy arena this trend has been most apparent in the

widespread move toward privatization and deregulation. And in the academic world there has

been increased respect shown to free market ideologies, even to policy views that would once have

been regarded as impractical. Surprisingly, monetary policy is one area that has been relatively

unaffected by the neoliberal revolution. Not only have governments retained a monopoly on fiat

money, but even some free market ideologues have been skeptical of proposals for laissez-faire

monetary regimes. This paper will show that market forces can greatly improve the effectiveness

of monetary policy.

I will argue that the Federal Open Market Committee (FOMC) should do no more than set the

goals of monetary policy. Sumner (1989, 1995) and Dowd (1994) argued that the creative use of

prediction markets for goal variables might allow central banks to more accurately target variables

such as inflation. I will briefly review the literature on policy futures markets, examine Bernankeand Woodford’s (1997) critique of policies that “target the forecast”, and then suggest some im-

provements in previous reform proposals.

More importantly, I show that policy future markets can address some of the key weaknesses

of orthodox macroeconomic theory and policy, particularly the lack of consensus over structural

models. Under this sort of policy regime, open market operations would reflect the views of not

merely 12 individuals, but rather the consensus opinion of all those who choose to engage in open

market operations. Even an issue as basic as the optimal monetary instrument would no longer

be determined by the monetary authority, instead, each individual participant in the policymaking

process would choose their own policy indicator. I will also show that a universal FOMC can

improve the effectiveness of monetary policy even if the average level of decision-making skills

on the expanded FOMC is inferior to the average skill level of the current 12 members.

KEYWORDS: monetary policy

∗Address: Department of Economics, Bentley College, Waltham, MA 02452. I would like to

thank Aaron Jackson and two referees for helpful comments and suggestions.



In recent decades there has been a worldwide shift toward market-orientedeconomic policies, sometimes termed ‘neoliberalism’. In the policy arena thistrend has been most apparent in the widespread move toward privatization and

deregulation. And in the academic world there has been increased respect shownto free market ideologies, even to policy views that would once have beenregarded as impractical. Surprisingly, monetary policy is one area that has beenrelatively unaffected by the neoliberal revolution. Governments have retained amonopoly in both the production of fiat money, and the implementation of monetary policy.

This paper has two primary objectives. First, to show that even wheregovernments retain a monopoly in the production of currency, a market-orientedsystem of open market operations can greatly improve the effectiveness of monetary policy. In section 4 I show that despite recent arguments to thecontrary, market forces can be introduced into monetary policy by creating a

regime based on index futures targeting. Then in section 5 I suggest a fewtechnical improvements to previous proposals for monetary regimes where openmarket operations are conducted using index futures.

The second objective is to provide several new arguments for adopting amarket-oriented monetary policy regime. Section 3 examines a key weakness of conventional monetary policies, the inability of macroeconomists to agree on theappropriate instrument of monetary policy. This provides one importantmotivation for the index futures targeting regime discussed in sections 4 and 5,which doesn’t force policymakers to choose any particular policy instrument.And then in section 6 I discuss how recent research in prediction markets provides powerful new arguments for introducing market forces into monetary

policymaking. I conclude by arguing that an index futures-based monetaryregime could be the first step toward broader reforms in our monetary system.But first we need to briefly examine why it has proven so difficult to incorporatemarket reforms into monetary policy.

2. Why Don’t We Have Laissez-faire Monetary Regimes?

During the 1970s and 1980s a number of suggestions were offered as to how thegovernment might be removed from the monetary arena, most famously Hayek’s(1976) proposal for “competition in [fiat] currency.” Many of the early proposalswere explicitly motivated by the perceived failures of government run fiat money

regimes, particularly the high and variable inflation rates experienced between themid-1960s and the early 1980s. More recently, however, most central banks have been able to deliver relatively low and stable rates of inflation, thus lessening the perceived need for radical policy reforms. Advocates of laissez-faire monetaryarrangements currently face at least two major hurdles in convincing others of the

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Sumner: Let a Thousand Models Bloom: Making the FOMC an 'Open Market'

Published by Berkeley Electronic Press, 2006



desirability of scrapping central banks and plunging into the uncertain world of privately issued currencies.

The first hurdle is to show that private currency issuers have both the

ability to discover the proper goals of monetary policy, and the incentive toimplement such a policy. Although competitive markets are often a marvelouslyeffective “engine of discovery”, the money market presents some extracomplications not present in other goods. Proposals for optimal monetaryregimes often begin by considering policies from a consumer welfare perspective,as in Friedman (1969). Unfortunately, because money is the “numeraire” bywhich other prices are specified, and because many wages and prices are “sticky”,changes in the real value of money can also impact employment and output.Given the myriad ways in which monetary instability can affect economicwelfare, can we be sure that the type of currency preferred by consumers wouldalso be socially optimal? Or does wage and price stickiness cause monetary

policy to have “external effects”?Presumably an ideal monetary policy would deliver something close to

price stability. But there remain significant differences among macroeconomistsas to precisely what form of ‘price stability’ is optimal. For instance Hayek (1987, p. 388) suggested stabilizing money in terms of “a defined index number”,Thompson (1982) favored stabilizing an aggregate wage index, whereas Hall(1986) advocated an “elastic price index”, i.e. minimizing a weighted average of price level and employment fluctuations. Of course advocates of central bank monetary policies must also justify their preferred policy goal; but the advocate of laissez-faire faces an even greater challenge, showing why private currencyissuers would have an incentive to aim for the price level path most likely to

produce macroeconomic stability.The second hurdle relates to policy implementation. How closely would

the actual price level under laissez-faire follow the time path preferred by privatecurrency issuers? Even with the best of intentions, it is not obvious that adecentralized system of private currency issuers would be able to effectivelyovercome the difficulties created by the various policy lags. It should beemphasized that none of these hurdles are necessarily insurmountable, indeedWhite (1987) and Dowd (1996) present some powerful arguments in favor of thistype of monetary arrangement. However, with even free market economists suchas Barro (1982), Hall (1986) and Friedman (1987) shying away from completelaissez-faire in money, it appears that reform will need to proceed in a piecemeal

fashion. In section 7 I explain how the reforms discussed in this paper mightactually facilitate the implementation of other reform proposals, such as free banking.

During the late 1980s and the 1990s much useful work continued to bedone on topics such as free banking, indirect convertibility, and index futures

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Contributions to Macroeconomics , Vol. 6 [2006], Iss. 1, Art. 8

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targeting. In section 5 I discuss how this work relates to the proposal developedin this paper. Unfortunately, an important paper by Bernanke and Woodford(1997) challenged what I believe is the most promising way of bringing market

forces into monetary policymaking, index futures targeting. In the nine yearssince the Bernanke and Woodford paper was published, there has been relativelylittle progress in research on market-oriented monetary reforms. Instead, most of the research on monetary policy has been in the new Keynesian tradition—with afocus on developing policy rules for central banks, such as inflation targeting or the “Taylor rule.”

Today there is a need for proponents of market-oriented monetary reformsto do a better job of addressing the issues of greatest concern to orthodoxmacroeconomists. In the next section I discuss a major flaw in orthodoxmonetary economics, the fact that policy proposals assume a “consensus model”,even though there is still no consensus regarding issues as basic as the

transmission mechanism for monetary policy. This will then be used to motivatethe market-oriented policy developed in sections 4 and 5.

3. Why are there So Many Different Approaches to Monetary Economics?

One fairly standard approach to monetary economics is to write down a structuralmodel of the economy, and then compare the performance of various monetary policy rules in that hypothetical economy. McCallum (2002) suggests that wedon’t know the “true” model of the economy, and he advises looking for robust policy rules, that is, policies that perform relatively well under a wide variety of structural assumptions. The market-based policy discussed in sections 4 and 5

will take this eclectic approach to its logical conclusion. Monetary policy wouldreflect the decisions of thousands of market participants, each using their ownstructural model. Because model uncertainty is such an important motivation for this proposal, we need to examine this problem more closely.

The questions we need to address are: Is there a consensus model for usein monetary analysis? If not, why not? And what are the prospects for developing such a model in the near future? Blanchard’s (2000) survey of macroeconomics during the 20th century takes what is sometimes referred to as a“Whig” view of the history of economic thought, with the field of macroeconomics exhibiting relatively steady progress toward better and better models of the economy. Friedman (1975) takes a more skeptical view, arguing

that the core theoretical innovations mostly relate to our better understanding of the distinction between a change in the price level and a change in the rate of

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inflation.1 During the 1960s and 1970s (after most countries adopted inflationaryfiat money regimes) economists did develop a greater understanding of thedistinction between real and nominal interest rates, and how changes in inflation

expectations can shift the Phillips Curve. These insights about the impact of policy on expectations led to a series of theoretical innovations that culminated inthe Lucas Critique.

The rational expectations revolution clearly improved our understandingof aggregate supply, particularly when compared to earlier Phillips curve models.In this paper, however, we are concerned with the implementation of monetary policy, not the proper goals of policy. That is, the question is how to best controlaggregate demand, not what is the proper level of aggregate demand.Unfortunately, there is as yet no consensus about how to model the money supplytransmission mechanism, nor is there agreement as to the proper instrument of monetary policy. Consider the policy views of these five distinguished monetary

economists:

1. Michael Woodford—Favors policy rules with interest rate instruments aimedat stabilizing the price level. Recent work is perhaps closest to a “consensusmodel”.

2. Bennett McCallum—Favors policy rules with a monetary base instrumentaimed at stabilizing nominal GDP growth.

3. Milton Friedman—Favors steady growth in broader monetary aggregates suchas M2.

4. Robert Mundell—Favors fixed exchange rate regimes.

5. Robert Hall—Advocated a price level targeting scheme involving interest bearing bank reserves. Higher rates on reserves would lower demand for reserves, and thus raise the price level. Hall (1982) also proposed monetary policies aimed at targeting the price of a specified basket of commodities.

What is most interesting about the preceding list is not that each economisthas their own preferred approach to monetary policy, but rather that these policyrecommendations are based on fundamentally distinct ways of thinking about

monetary economics in general. Even more striking is that this diversity existsamong economists who in many ways are right in the mainstream—none of the

1 In discussing the Phillips curve issue, Friedman (1975, p. 177) argued that “As I see it, we haveadvanced beyond Hume in two respects only: first, we now have a more secure grasp on thequantitative magnitudes involved; second, we have gone one derivative beyond Hume.”

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five are ‘traditional Keynesians’ who deny that the long run aggregate supplycurve is vertical, nor do any adopt the extreme New Classical position of complete wage and price flexibility in the short run. How can we explain this

diversity?To begin at perhaps the most basic level; it is not clear that the preceding

five economists would even agree on what is meant by the term ‘monetary policy’. Friedman and McCallum might argue that at its essence, monetary policyis control of the quantity of money, however defined. Mundell (2000) and Hallmight argue that monetary policy is basically a change in the price of money (interms of foreign exchange, or gold, or a basket of commodities). Woodfordrepresents the mainstream view, which sees monetary policy in terms of changesin the rental cost of money, i.e. short term interest rates.

It should be obvious to anyone who follows the debate over monetary policy that these various perspectives strongly influence economists’ policy

recommendations. One need only examine the recent debate over the Japanese“liquidity trap” to see a striking confirmation of the link between how economistsapproach monetary analysis, and what sort of policies they recommend. Amonetarist who focuses on the relationship between the quantity of money and the price level would not see a zero interest rate as being a constraint on policy. Theywould recommend a policy of monetary expansion, or “quantitative easing”,which would raise Japan’s expected future price level and thus reduce the currentlevel of real interest rates. Eggertsson and Woodford (2003) also sawexpectations as a key to understanding the liquidity trap, but doubted the efficacyof quantitative easing. Instead they favored policy options such as committing tohold nominal interest rates at zero until some time after Japan had exited from the

liquidity trap. A third group has taken a “price of money” approach to policy,arguing that Japan should depreciate the yen against other currencies2.

In this section I have mentioned only a few of the areas in whichdifferent approaches to monetary analysis lead to different policy views.Monetary economists also differ in their views of the relative importance of money illusion, wage stickiness, and price stickiness in the aggregate supplyfunction. They differ in their views of what causes short run price stickiness3. Infact, there isn’t even any general agreement as to what one means by “the” pricelevel. Is it the average price of newly-produced consumer goods, or should itinclude many other assets such as the stock of existing capital goods? Each areaof disagreement has a multiplicative impact on the total number of potential

model permutations. Given this complexity, it is unlikely that any two prominentmacroeconomists have precisely identical views as to how best to model themacroeconomy.

2 See Svensson (2003b).3 McCallum (2002, p. 84-85, ft.) lists ten different models of short run price stickiness.

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Of course it is human nature to think one’s own views are best, and thatother economists can eventually be persuaded to see the light. But for policy purposes, it is also important to be realistic about the degree of consensus that the

field of monetary economics is likely to reach in the near future. All of the perspectives mentioned above, the quantity, price, and rental cost approaches to policy, as well as the short run sticky-price and long run classical frameworks, go back at least two centuries. It is not obvious what sort of empirical findings, if any, could determine who’s right and who’s wrong, or indeed whether any singleapproach is optimal under all circumstances. The most important motivation for this paper is the need to develop a monetary policy regime that is robust to not just a handful of structural models in the new Keynesian tradition, but to virtuallyany mainstream approach to monetary economics.

The recent dispute over Japanese policy options suggests that mainstreameconomists have failed to reach a consensus over questions as basic as what

constitutes the appropriate instrument of monetary policy. The policy proposaldiscussed in the following two sections sidesteps this problem in a quite elegantway; we will develop a policy regime that lacks any policy ‘instrument’—at leastin the conventional sense of that term. Nor is there any need for policymakers toagree on the appropriate structural model of the economy.

4. What Would a “Market-Oriented” Monetary Policy Look Like?

In the next two sections we will assume that the Federal Open Market Committee(FOMC) focuses solely on establishing the goals of monetary policy. The actualimplementation of policy would be opened up to the general public, with open

market operations reflecting the views of not merely the 12 individuals whohappen to be serving on the FOMC, but rather the consensus opinion of themarket as a whole. In section 5 I examine some of the practical problemsassociated with constructing this type of policy regime. Then in section 6 we willsee how competition can improve the effectiveness of monetary policy, even if the average level of decision-making skills on an expanded FOMC is inferior tothe average skill level of the current 12 members.

In order to develop a market-oriented monetary policy we first need tothink about how we can induce market participants to make socially constructivedecisions, i.e. to engage in open market purchases or sales that are expected toreduce the deviation of the monetary goal variable(s) from its target value. For

our purposes, the term ‘market-oriented’ will refer to a regime where there is freeentry, and participant rewards are positively correlated with the (social) productivity of their activities. The ‘free entry’ part is relatively easy to explain— all individuals and institutions would be allowed to undertake open marketoperations. The issue of how to reward monetary policy participants is much

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more complex, and we will begin by considering how the current FOMC mightreward individuals for their decisions, or more precisely, their contributions to“the” decision.

It turns out that there is a relatively simple way of rewarding monetary policy decision-makers. For instance, assume that under the current policyregime the Fed has a 2% inflation target for the next 12 months, and that thecommittee uses a median voter procedure to set the fed funds rate target at 4.5%.Then the six (hawkish) FOMC members who advocated a fed funds target above4.5% will presumably be concerned that the lower actual instrument setting will prove to be too expansionary, and will push the inflation rate above 2%. The sixdovish FOMC will presumably have the opposite expectation.4 In that case, onecould link part of each FOMC members’ salary (for that meeting) to the realizedinflation rate over the following 12 months. If actual inflation turned out to beabove the 2% target, then the hawkish members would receive a higher salary,

and vice versa. But if we contemplate extending the “one-person-one-vote” procedure to all 300 million Americans, we would need to confront the fact thatmost people are extraordinarily uninformed about monetary policy.

It is generally assumed that markets aggregate information mostefficiently if prices are determined on a “one-dollar-one-vote” basis, rather thanone-person-one-vote. In that case, one could imagine the central bank setting up aCPI futures market where all trades are contingent on the setting of the monetary policy instrument. Using the aforementioned policy goal, the CPI futurescontracts would have a par value of (1.02)*(current CPI). Traders who expectedhigher than target inflation would take a “long” position, and vice versa. As in themarket for Treasury bills, this would be a contingent auction with each trader

filling out an offer sheet listing their preferred long or short position at various policy instrument settings. In this case, the only trades that would be executedwould be the offers that were contingent on the actual setting of the policyinstrument. And that instrument setting would be the value that most nearlyequilibrated the short and long positions in the CPI futures market. For example,CPI futures long and short positions might be most nearly equalized on contractscontingent on a 4.25% fed funds rate target. In that case, at higher potentialinstrument settings (tighter money) shorts would have exceeded long positionswhereas at instrument settings below 4.25% the long positions would haveexceeded the shorts5.

The CPI futures approach certainly brings the market much more deeply

into the monetary policymaking process. If markets are efficient, or more

4 Of course this is only true if there is a generally agreed upon policy goal (2% inflation in thiscase). When we move to a market-oriented regime, the strict separation between decisions aboutthe goals of policy, and how best to implement those goals, will become much clearer.5 Sumner (1997) discussed a similar proposal.

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precisely if the market price of CPI futures is equal to the optimal forecast, thenthis system would represent an ideal form of the “forecast targeting” advocated bySvensson (2003a), and others. Unfortunately, this system would require a

cumbersome apparatus where each participant in the market makes a set of offersthat are each contingent on various settings of “the” policy instrument. Moreimportantly, even if this type of policy regime improved the effectiveness of monetary policy (by reducing the volatility of inflation), it doesn’t address one of the fundamental issues raised in section 3, the lack of consensus as to the optimal policy instrument . Should the policy instrument be the fed funds rate, themonetary base, or the price of foreign exchange? And as we have seen, thisquestion is most likely to arise in precisely those situations where effectivemonetary policy is most needed6, which is when expectations are most unstable.In order to fully incorporate the potential efficiencies of the market into policymaking, we need to consider a policy with no monetary instrument, or more

precisely, one where each market participant can conduct open market operationsusing their own preferred policy indicator.

Because a policy regime without a unique instrument may seem somewhatunfamiliar, we need to consider what the term “policy instrument” actuallymeans, and what it does not mean. In the recent literature it does not generallymean “the variable directly impacted by monetary policy”, but rather somethingcloser to “operating target”7. Monetarists may favor a reserve instrument,whereas Keynesians generally favor use of a short term interest rate, but bothwould presumably agree that open market operations usually impact both the base, and short term interest rates. A variable becomes a policy instrument when policymakers directly target the variable, perhaps because they believe it provides

the best indicator of the stance of monetary policy. Monetarists see a fallingmoney supply as being indicative of tight money, Keynesians see rising (real)short-term rates as indicative of tight money, and some “supply-siders” mightfocus on falling commodity prices.

How could the central bank adopt a market-oriented monetary policywithout any policy instrument? One answer would be to allow private sector open market operations. Of course under a government fiat money regime a‘private sector open market purchase’ is just a fancy term for counterfeiting. For the moment let’s assume that the central bank intends to retain its monopoly onthe revenue from money creation, i.e. seignorage. In addition, we also want to

6 For example, interest rate targeting has been relatively effective in recent decades—except whenan effective monetary policy has been most needed, i.e., in Japan during the past decade.7 McCallum (2000, p. 72) points out that there is some ambiguity as to the distinction between anindicator variable and a policy instrument. Here I am using the term ‘instrument’ in the sense inwhich it is used in the Keynesian/monetarist policy debates, i.e., the monetary base and short termrates are alternative policy instruments.

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reward traders who engaged in open market operations that, ex post, appear tohave helped move the economy closer to achieving the central bank’s policygoals. Fortunately, both the seignorage and incentive issues can be addressed

with the same policy set-up, a system of private sector purchases and sales of CPIfutures, each of which trigger parallel central bank open market purchases andsales8.

The Fed could announce that it is willing to buy or sell unlimitedquantities of CPI futures with a par value equal to the target price level. If therewas a 2% inflation target, then traders expecting above target inflation might purchase $10,000 worth of CPI futures with a par value of (1.02)*(current CPI).This purchase would trigger a parallel $10,000 open market sale by the Fed.Similarly, a sale of $10,000 worth of CPI futures by the public would trigger anequivalent open market purchase by the Fed. Only the central bank operationswould directly impact reserves and interest rates. But because the central bank

would respond automatically to private sector activity in the CPI futures market,in a very real sense the private sector would be conducting monetary policy.

It might seem odd that traders would buy and sell CPI futures if theythought that their actions would put monetary policy back on target, and thuseliminate the profits that result from deviations between the actual CPI and itstarget value. But recall that expectations are heterogeneous. Because traders’expectations are based on a wide variety of different structural models, their forecasts will be similarly diverse. As with any futures market, in equilibriumthere will be traders taking both long and short positions. Unlike ordinary futuresmarkets, however, equilibrium is not established by movements in the market price (which is fixed by the Fed at its policy goal). Instead, equilibrium would be

established as trades of CPI futures contracts shifted monetary policy, and hencemoved the expected rate of inflation closer to the policy goal.

It is interesting to consider just how far this proposal moves us from thecurrent monetary policymaking set-up at the Fed. Bernanke and Woodford(1997) argued that central banks could not simply target an external forecast, theyneeded their own structural model. As we have already seen it is a mistake tothink in terms of “the” structural model, even FOMC policy decisions are almostcertainly (at least implicitly) based on 12 distinct structural models. Moving to amarket-based approach means that policy would be based on a still larger set of structural models. In addition, this regime would move us from a ‘one-person-one-vote’ open market committee structure, to a ‘one-dollar-one-vote’ decision-

making process. And it would also establish a more market-oriented rewardsystem.

8 The following is loosely based on earlier proposals by Sumner (1989) and Dowd (1994).

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One of the greatest advantages of this sort of market-oriented monetary policy is that it does not require policymakers to agree on the optimal instrumentof monetary policy. Each member of the public can use their own preferred

policy indicator. The market’s implicit policy “instrument” might be a weightedaverage of various asset prices. For example, under the policy regime discussedabove, a liquidity trap would lead investors to buy or sell CPI futures until themoney supply and/or the prices of foreign exchange, equities, and commoditieshad risen to a level where the market expected an inflation rate of 2 percent9.

If the preceding list of changes seems rather modest, it may be because themost important controversies in the field of monetary policy relate to the proper goals of policy, not the best instrument for achieving those goals. Even under themarket-oriented approach discussed in this paper, we have assumed that the goalof policy would be set by the monetary authority, perhaps the FOMC. Becausethere is no generally accepted model showing the linkage between changes in

measurable economic aggregates such as prices and output, and the essentiallyunmeasurable elements of a social welfare function (such the menu costs of pricechanges and suboptimal employment fluctuations) there is no obvious way bywhich the market could determine the appropriate goals of policy.10

Thus far I have skipped over a variety of practical problems associatedwith the incorporation of the private sector into the monetary policymaking process. In the next section I consider some of the objections that have beenraised to previous market-oriented monetary policy proposals. I then show thatthese objections are either inaccurate, or are easily remedied.

5.a Previous Market-Oriented Monetary Policy Proposals

There is a long history of market involvement in monetary policy. During thenineteenth century, for instance, currency was often issued by private commercial banks. More recently, the “free banking” tradition was revived by Hayek (1976), but his proposal for competing fiat currencies raised questions as to how the pricelevel would controlled. Soon after, a number of proposals11 were offered for payments systems that lacked money in the traditional sense, and where the

9 Under a monopoly central bank there is a greater risk that policies of “quantitative easing” or currency depreciation could lead a country to undershoot or overshoot in its attempt to exit from aliquidity trap.10

Sumner (1995) and Tinsley (1999) showed how the market could be used to make those goalsmore credible by making it more costly for the central bank to adjust the target path of the goalvariable. In deciding whether to constrain its actions in this way the central bank would need toconsider the cost of unanticipated changes in the policy goal, as well as the benefits associatedwith adjusting their policy goals as new theoretical insights become available about the socialwelfare costs of various types of policy outcomes.11 See Black (1970), Fama (1980), Hall (1982), and Greenfield and Yeager (1983).

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government’s role was limited to defining the unit of account in terms of a basketof commodities.

Unfortunately, it is not easy to avoid using money for at least some

transactions, media of exchange with a fixed nominal value are exceedinglyconvenient. But how can we be sure that the overall price level remains stable interms of those nominal assets? Greenfield and Yeager (1989) suggested that the price level could be stabilized under a free banking system where various mediaof exchange were indirectly convertible into a standard commodity bundle. Thatis, “dollars” could be converted into a quantity of gold with fixed purchasing power. But Schnadt and Whittaker (1993) argued that this type of system couldlead to a “paradox of indirect convertibility” which would make the systemsusceptible to destabilizing arbitrage12.

Sumner (1994) argued that indirect convertibility could work, but only if the standard bundle was composed of commodities with flexible prices, traded in

auction-style markets. He suggested that the paradox of indirect convertibilitywas actually a variant of the “policy lag” problem that faces any monetaryregime; because of sticky prices there is a long lag between changes in monetary policy, and changes in the overall price level. At about this time a number of proposals were developed by Hall (1983), Sumner (1989, 1991), Hetzel (1990)and Dowd (1994) which aimed at stabilizing the overall price level by usingmonetary policy to peg the current price of a financial contract linked to the future price level. Woolsey (1992) and Dowd (1993) recognized that because the priceof index futures contracts was flexible, i.e. their price would respond immediatelyto changes in supply and demand, these futures contracts could be effectivelyincorporated into the sort of indirect convertibility scheme envisioned by

Greenfield and Yeager (1989). In section 7 I will show how the Woolsey/Dowd papers suggest a way that the reforms discussed in this paper could open the door to further market reforms of the monetary system.

Hall (1983) developed one13 of the first modern proposals for a market-oriented monetary policy that would target an economic aggregate. Hallsuggested that the central bank could pay interest on bank reserves and that theinterest rate should have two components. Reserves would earn a nominalinterest rate roughly comparable to the rate on risk-free short term assets, plus anadditional component indexed to changes in the price level. An increase in the

12 If there were an increase in the price of the standard bundle, then media of account would suffer

a temporary drop in purchasing power. This would encourage individuals to redeem currencynotes for enough gold to purchase the standard bundle. The quantity of currency in circulationwould decline and the price of the standard bundle would return to equilibrium. If, however, thestandard bundle also contained goods with “sticky” prices then there might be a delay in therestoration of equilibrium, thus providing arbitrageurs with an unlimited profit opportunity.13 As far as I know, the basic idea behind index futures targeting was first mentioned in anunpublished paper by Thompson (1982).

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expected price level would sharply increase the demand for reserves, thusincreasing their real value (or purchasing power). Since reserves would serve asthe medium of account, an increase in the real value of reserves would tend to

reduce the overall price level. Conversely, a decrease in the expected price levelwould reduce the expected return on reserves, reduce their value, and thus raisethe price level. Hall argued that these reserves would be close substitutes for other risk-free short term securities. If so, then the demand for reserves would behighly elastic with respect to the indexation portion of the interest rate, and the policy regime would automatically tend to stabilize the (expected) price level.Hall also noted that by suitably adjusting the indexation component of the interestrate on reserves, the proposal could be amended to target any nominal economicaggregate.

Although Hall’s proposal envisioned using market expectations to shift thedemand for money, most market-oriented schemes attempted to stabilize the price

level by having market expectations influence the supply of money. Hetzel(1990) suggested that the central bank could use open market operations to targetthe spread between nominal and indexed bond yields. Sumner (1989, 1995) andDowd (1994) suggested creating a consumer price index futures market, and thenusing this futures market to implement monetary policy. At this point Bernankeand Woodford (1997) published an important critique of all monetary policies that“targeted the forecast”, specifically citing the proposals of Hetzel, Sumner, andDowd.

Consider a policy regime where the central bank tightened monetary policy whenever CPI futures with a 12 month maturity rose more than 2% abovethe current CPI, and vice versa. Bernanke and Woodford showed that if the

private sector anticipated these preemptive moves, and if the policy werecompletely credible, then the price of CPI futures contracts would never riseabove its target value, and hence there would have been no market signal for thecentral bank to have responded to in the first place. This dilemma, variouslytermed the “circularity problem” or the “simultaneity problem,” would seem to preclude the development of monetary regimes where central bank policy was based solely on private sector forecasts. And Bernanke and Woodford’s critiquecould apply to any forecast targeting regime, even if the forecast was developed by a research unit within the central bank. The circularity problem applies to any policy based on a forecast that is unconditional, that is, not linked to a specifiedsetting of the policy instrument.

It turns out that Bernanke and Woodford were only half right. Thecircularity problem does apply to Sumner’s (1995) suggestion that the Fed peg the price of a CPI futures contract, and Hetzel’s (1990) proposal that the Fed peg thespread between the yield on conventional and indexed bonds (which is presumably a proxy for inflation expectations.) If these policies were credible,

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then the policy indicator would always signal price stability, and thus would beunable to send the Fed timely signals of a need to adjust policy. Their analysissuggests that the central bank should not use open market operations to target the

price of a futures contract linked to the policy goal variable. But Bernanke andWoodford’s critique does not apply to the policy regimes suggested in Sumner (1989) or Dowd (1994), under which open market operations are determined bythe private sector.

Bernanke and Woodford argued that the central bank would benefit muchmore from market forecasts of the goal variable if they were accompanied byforecasts of the policy instrument. One example would be a CPI futures targetingregime where proposed trades were contingent on various instrument settings, asdiscussed in the previous section. Recall that under that type of regime the Fedwould only execute those trades that were contingent on an instrument setting thatequated the CPI futures price and the policy goal (2% inflation in this example.)

The auction would not be structured to elicit private sector forecasts of inflation— the price of CPI futures would be pegged by the Fed—instead the market would be signaling the instrument setting most likely to achieve the policy goal. Thistype of policy regime would not be susceptible to the circularity problem.

Even better, consider policy proposals in which the Fed allows the private sector to engage in open market operations in index futures contracts at a fixed price (as in Sumner, 1989, and Dowd, 1994). Under those policy regimes the private sector doesn’t signal a need for policy changes via fluctuations in a futures price index; instead, if the market perceives the need for an adjustment in themonetary base, it signals that perception by directly engaging in open marketoperations, thus eliminating the circularity problem. Unlike with Sumner (1995)

and Hetzel (1990), the proposal for private sector open market operations actuallyelicits an (implicit) market forecast of the quantity of money most likely toachieve the policy goal, exactly the sort of private sector forecast that Bernankeand Woodford suggested could be helpful to policymakers14.

In Hall’s (1983) proposal the central bank is essentially passive, and thusit also avoids the circularity problem. Hall’s paper is a brilliant piece of work thatwas unjustly ignored, perhaps because it was so far ahead of it’s time. But thereare a few reasons to doubt whether Hall’s plan is the best way to incorporatemarket expectations into the monetary policy arena. Most of the monetary base iscomposed of currency. In principle, interest could be paid on currency, but thetransactions costs involved probably make such a plan impractical. One could

envision paying interest on only the reserve portion of the base, but this wouldgreatly restrict the size of the “market” which would be used to implementmonetary policy. Many countries have only a few commercial banks, and others

14 See Jackson and Sumner (2006) for an alternative solution to the circularity problem.

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have many small commercial banks with little expertise in forecasting nominalaggregates. In addition, during a liquidity trap the expected return on bank reserves might become negative and (non-interest-bearing) cash would dominate

reserves. In that case it is difficult to see how both assets could serve as thenumeraire.

The Sumner and Dowd proposals are also susceptible to several potential problems. Because they envisioned targeting monthly or quarterly economicaggregates, these proposals would seem to be susceptible to an “end of period problem,” which is actually two distinct problems. One problem, which I willterm ‘instrument instability’ occurs when important new information about thelikely future path of inflation arrives in the marketplace very late in a giventargeting period. For instance, suppose that between October 1 and October 31,2006, the Fed was targeting October 2007 inflation. Also suppose that in lateOctober, 2006, the market received new information indicating that prices were

rising much faster than anticipated, and that next year’s inflation rate was likely toexceed its target value. This would trigger massive inflation futures purchases, ahuge decrease in the monetary base and a huge increase in the fed funds rate. Butthere is relatively little that one or two days’ worth of “tight money” can do tooffset mistakes that had been made over the previous month.

A second, and more serious, end of the period problem is the “first mover disadvantage” discussed by Garrison and White (1997). The trading of inflationfutures will determine monetary policy, but monetary policy will also determinefuture inflation. Thus it is in the interest of traders to know the stance of monetary policy before they make their trades. In the previous example, thetrader that trades last on October 31st, 2006 will have the best information about

monetary policy during October 2006, and thus will have an advantage inforecasting next year’s inflation. If all traders wait until the last minute, however,then they will be forced to make inflation forecasts without knowledge of thestance of monetary policy, i.e. the total amount of open market sales or purchases.In addition, if traders waited until the last minute to engage in their trades, thenthere wouldn’t be enough time for monetary policy to impact the price level.

Dowd (2000) noted that Garrison and White’s critique was not applicableto his proposal because all trades for each contract would occur on a single day,and because trades on a specific contract would occur well before the maturitydate. In addition, as with Bernanke/Woodford, the Garrison and White critique isactually more relevant to Sumner’s (1995) proposal, in which the central bank had

to respond to changes in the price of futures contracts. In that case, if traderswaited until the last minute then they would have to trade without knowledge of how the central bank had adjusted the money supply in response to their indexfutures trading.

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Even with the superior schemes of Sumner (1989) and Dowd (1994),however, there is some ambiguity as to exactly how the money supply would bedetermined over the course of each targeting period. They envisioned futures

market transactions directly and fully determining the monetary base. The publicwould be required to take a massive short position during each period in order for the central bank to inject hundreds of billions of dollars of base money into theeconomy. This would represent a huge loan by the central bank to the public,which would be fully repaid at the announcement date for the goal variable. Atthat moment, massive quantities of base money would flow back to the central bank, only to be re-injected by a new CPI futures auction. These policy regimesseem unnecessarily cumbersome and inefficient. In the next section we will look at a policy proposal that addresses some of these inefficiencies.

5.b Is a Market-Oriented Monetary Policy Regime Actually Workable?

Because the idea of allowing the market to implement monetary policy is sounfamiliar, it will be useful to consider some of the practical problems in thecontext of a specific example. It is important to keep in mind that all of thespecific parameters used in this section will be arbitrary, and could easily bemodified by the central bank. For ease of exposition, I will consider a 3.65%inflation target, with no allowance for base drift. With no loss of generality wecan assume that the (log of the) current level of the CPI is 1.0, and the one year forward goal is for a CPI of 1.0365. (Note that the proposal could be easilyamended if policymakers preferred a nominal income growth target.)

As discussed earlier, we could implement this policy by having the Fed

create a CPI futures market, where each contract has a par value of 1.0365, andthen have the Fed offer to buy or sell unlimited quantities of CPI futurescontracts. If this system were adopted at the beginning of a new monetary regime(say at the beginning of American history), then by now the Fed would be takinga huge “long” position equal to the current size of the monetary base, i.e. roughly$800 billion dollars. This would be necessary because, in order to prevent theCPI from falling below its target level, the public would have to take a short position in the CPI futures market large enough to spur the Fed into buying $800 billion dollars worth of CPI futures, and thus injecting $800 billion worth of basemoney into the economy. To avoid assuming the risk associated with such anextreme position, the Fed would probably want to start off each period with a

stock of base money equal to the forecasted equilibrium value. This might beroughly equal to last period’s equilibrium stock of base money after thecompletion of open market operations, plus an adjustment to reflect predictablesecular, seasonal, holiday, and day of the week variations in the demand for basemoney.

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In addition to deciding how far out in the future to target CPI (what I willterm the ‘maturity’ of the goal variable), the Fed would have to decide theduration of the goal variable. But we have already seen that a relatively long

targeting period creates an ‘end of period problem’. It may not be possible toeliminate the end of period problem (except by returning to the contingent auctionformat) but the problem can be greatly reduced by having the governmentcompute a new monthly CPI estimate each day, or 365 times each year. Becausethe government now estimates the CPI only monthly, the other 353 estimateswould be generated by taking a weighted average of two consecutive monthlyestimates. Thus the estimate for November 25th would be for a 30 day periodsurrounding that date. The period would extend 10 days into the next month, andthus the estimate would be roughly 2/3 times the November CPI plus 1/3 timesthe December CPI (both seasonally adjusted).

Because we are assuming a 3.65% growth target for the CPI with no base

drift, each day the Fed would be issuing new CPI futures contracts with a par value that was 0.01%, or one basis point, higher than the target of the previousday. Traders who waited more than 24 hours to get better information on the 12month ahead CPI would find that the contract they had researched was no longer being traded. Of course there would still be some incentive for traders to waituntil late in the trading day. Efficient markets theory suggests, however, that anydaily errors due to ignorance of the intentions of other traders would be seriallyuncorrelated, and it is implausible that the random error in a single day’smonetary policy would have a significant impact on long run macroeconomicstability.

The efficiency of a market is almost certainly related to its depth. One

way of sparking interest in a CPI futures market is by having a low marginrequirement on purchases and sales of CPI futures contracts. On the other hand, if the margin requirement were set too low, then the central bank would be exposedto default risk. Assume that the Fed decided that a 10% margin on one year forward CPI futures would be large enough to reduce default risk to a negligiblelevel. The Fed might also decide to pay interest on the margin accounts, perhapsat a rate equal to the yield on one year T-bills. If the market remained too thin,the Fed could increase the interest rate on margin accounts above the T-bill rate,until there was sufficient trader interest to create an efficient market15.

To see how this might work in practice, consider an example using the parameters discussed above. On November 25th, 2006, the Fed trades CPI futures

contracts with a par value of 1.0365, and a maturity of one year. Assume the 10%

15 A study of prediction markets by Wolfers and Zitzewitz (2004) found that turnover at the IowaElectronic Markets was only in the $10,000s per event, and in the $100,000s per event atTradesports.com. Yet even markets this thin were found to have had an impressive forecastingrecord.

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margin accounts pay 6% interest per annum. Now consider an example whereone trader bought $10,000 worth of CPI futures and another trader sold an equalamount. Assume that because of the overlapping period problem, and the data

lag, the level of the CPI on November 25th, 2007 is not calculated until twomonths later, when it is found to be 2% above target. In that case, on January25th, 2008, both positions will be settled. Each trader would then receive a payment from the Fed with three components; the original margin requirement($1000), 14 month’s worth of interest ($70), and a third component that representstheir “reward” for contributing to the monetary policymaking process. Because inthis case the actual CPI came in 2% above target, the trader who took a long position will receive a $200 bonus, and a total payment of $1270, whereas thetrader taking a short position will receive a $200 penalty, and thus a total paymentof $870.

The effectiveness of this type of policy regime depends on both the

forecasting ability of the market, and the efficiency of the CPI futures market.There are two reasons why this policy regime might fail to achieve its policygoals. The market forecast of next year’s CPI may not be the optimal forecast, or the price of CPI futures may not be equal to the market forecast. While it isobviously difficult to know exactly how well the market would be able to forecastthe CPI under such a policy regime, in section 6 I will suggests several reasonswhy the market is likely to do a better job than the FOMC.

There is also no easy answer to the market efficiency question. If thereare many people who wish to hedge against CPI risk, then there may16 be a risk premium built into the price of CPI contracts. But when CPI futures markets have been created, there has been relatively little trading, which suggests that there is

limited interest in that sort of inflation hedge, and therefore that the price of CPIfutures contracts is unlikely to be seriously biased by a risk premium. Ironically,the very lack of interest in previous real world economic aggregate futuresmarkets is actually a point in favor of employing them for policy purposes. The price of CPI futures contracts is more likely to reflect the future expected CPI if traders are pure gamblers, not hedgers willing to accept a negative expected rateof return in exchange for insurance against unanticipated price level fluctuations.Of course this also suggests that in order to draw traders into such a market theFed would probably have to offer a rate of return on margin accounts that wassomewhat above the yield on one year T-bills.

Even if the price of CPI futures did include a risk premium, and thus the

price of the contracts was not equal to the market forecast, a market-orientedmonetary policy might still deliver relatively stable macroeconomic conditions.In the long run, what matters isn’t so much the level of the CPI but rather its

16 Unless hedgers were equally distributed on both sides of the market, the price of CPI futurescontracts would diverge from the future expected value of the CPI.

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volatility. Unless the risk premium was time-varying, it would only have a one-time impact on the level of the CPI, with no permanent impact on the moreimportant long run policy goal of 3.65% inflation.

The preceding example suggests that a workable market-orientedmonetary policy regime is certainly feasible. The purpose of this paper, however,is not merely to suggest improvements in previous market-oriented policy proposals, but also to show that economists have overlooked some of theadvantages of a market approach to monetary policy. One of the most importantadvantages is discussed in the following section.

6. Why Should We Trust the Market more than the FOMC?

Previous proposals for a market-oriented monetary policy have focused on issuessuch as the information lag. Sumner (1989) used an “island economy” set-up to

show that in a highly decentralized economy the market may have superior information about the current state of aggregate demand. It seems likely,however, that improvements in information technology will gradually erode anymarket advantage in that area. Here I would like to argue that it is the problem of model uncertainty that is paramount, and that the most significant gains frommoving to a market-oriented approach to policy come from the way that marketsaggregate forecasts where there is a diversity of opinion on the optimal model of the economy.

Even if we had perfect information about the current state of the economy,monetary policy’s long and variable impact lag makes it difficult to predict theeffect of a given instrument setting on future movements in prices and output.

Whether policy is being made by the FOMC, or by the market, policymakers mustforecast the impact of policy on future movements in the goal variable. But whywould market participants be better at forecasting than the members of theFOMC? I would like to consider this question from several different perspectives, beginning with a meta-analysis of money demand studies.

Stix and Knell (2004) showed that in 503 previous money demand studiesthe mean estimate of the income elasticity of demand was 0.99 and the medianestimate was 1.00, which is essentially equal to the predicted value in manyconventional models of money demand. But because these studies varied in termsof time period, location, and definition of the monetary aggregate, the standarddeviation of these income elasticity estimates was a surprisingly large 0.46.

Unfortunately, we do not know the true income elasticity of money demand (nor if there is a “true” elasticity that is stable across time and region). Nevertheless,assume for the moment that the true income elasticity is close to unity. In thatcase it would be easy to envision a scenario where forecasts of this key parameter by central bank economic research departments were, on average, superior to

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most private forecasts, and yet far inferior to the “market” estimate (here proxied by the median value in the Stix and Knell study).

Of course the preceding example doesn’t prove that markets are

necessarily superior to centralized decision-making, but it suggests that if marketsare capable of efficiently aggregating private information, then even a relativelyhigh level of ‘noise’ in individual forecasts might well be associated with highlyaccurate market forecasts. In a study of policy advice from multiple experts,Battaglini (2004, p. 1) found that “the inefficiency in communication converges tozero as the number of experts increases, even if the residual noise in experts’signals is large [and] all the experts have significant and similar (but notnecessarily identical) biases”. And an experimental study by Lombardelli, Talbot,and Proudman (2002) showed that groups made better decisions than individualswhen asked to control “a simple macroeconomic model that was subject torandomly generated shocks in each period.”

Further support for the market-based approach to policy comes from theincreased popularity of artificially created markets, such as the Iowa ElectronicMarkets and Tradesports.com. Smith (2003, p. 477) noted that the implicitforecast of political election outcomes in the Iowa Electronic Markets tended toshow a smaller forecasting error than the average exit poll. Wolfers and Zitzewitz(2004) discussed how more and more firms are constructing internal predictionmarkets as a way of eliciting forecasts of useful variables such as sales revenue.They argued (p. 121) that the “power of prediction markets derives from the factthat they provide incentives for truthful revelation, they provide incentives for research and information discovery, and the market provides an algorithm for aggregating opinions.” Their research suggests that these markets are often quite

effective, despite a relatively low volume of trading.Recent price volatility in tech stocks and real estate has created renewed

interest in market “bubbles”. There is now a fairly widespread perception thatmarkets often overshoot their fundamental values, and this has led to a great dealof skepticism about whether markets aggregate information efficiently. Of coursewe really don’t know much about what might cause a market bubble, or even howto go about identifying this type of phenomenon. But let’s assume that bubblesdo exist. Would this weaken the argument for basing policy on predictionmarkets? Here I will offer a contrarian view, that market bubbles may actually provide one of the strongest arguments in favor of letting the market set monetary policy.

Surowiecki (2004, pp. 23-65) argued that bubbles are caused by“groupthink”, or “herding” behavior. The key to avoiding this phenomenon is toinsure that decisions are made by diverse groups featuring a wide range of independent analysis. In fact, he argues that decentralized decision making willoften be superior even if the average intelligence of the group is lower than that of

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“expert” opinion. Surowiecki doesn’t deny that markets may also be susceptibleto groupthink--he even cites the overly-optimistic forecasts on internet trafficgrowth that echoed around Wall Street during the late 1990s. But he seems even

more concerned by the groupthink arising out of small insular committees, citingexamples such as the (unanimous) committee decision to approve the Bay of Pigsinvasion of 1961.

When viewed from this perspective, one cannot help wondering whether the Bank of Japan has too little diversity of opinion. And a study by Chappell,McGregor, and Vermilyea (2005) found much circumstantial evidence thatFOMC members face subtle pressure to reach unanimous decisions. Consider that even if there was complete uniformity of opinion about the optimal level of inflation, one would expect a wide diversity of views regarding the optimalinstrument setting. Yet despite that fact that not all FOMC members agree oneven the appropriate goals of monetary policy, dissents are relatively infrequent.

We obviously don’t know whether Surowiecki’s groupthink hypothesisexplains some or all bubble-like phenomena, although it’s not clear we have a better explanation. More importantly, however, we have become so conditionedto looking for bubbles in markets, that we may have overlooked the fact thatessentially the same phenomenon is much more common in decision making bysmall, homogeneous committees. If so, then large and diverse prediction marketsmay actually reduce the chances that monetary policy decisions become distorted by this sort of “market inefficiency”.

7. Concluding Remarks

Policymakers have a natural reluctance to engage in radical institutional changewithout strong evidence that outcomes will be improved. Therefore it may beuseful to briefly consider the prospects for monetary policy becoming moremarket-oriented in the near future.

Before implementing the sort of proposal discussed in this paper, central banks will want to see some experimental evidence that market-oriented policyregimes can improve the efficiency of monetary policy. This evidence could takeone of two forms. First, the Fed may decide to set up experimental games thatsimulate the environment that would be faced by index futures traders. The problem with this approach is that we don’t know the exact structure of the actualeconomy--and as we saw in section 3, model uncertainty is actually one of the

most important motivations for market-oriented monetary reforms.A more definitive test of the market approach could be safely undertaken

by first setting up the sort of subsidized CPI futures market discussed in section5.b, but initially segregating it from the policy arena. Then the Fed could run a“horse race”, comparing the forecasting ability of the market against the internal

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forecasts of the Fed’s economic research units. If the market produced superior forecasts, then this would be a signal to allow the index futures trades to begindetermining monetary policy. In the unlikely event that the Fed’s internal

forecasts were consistently superior, the Fed could become a “profit center” for the federal government by trading on their forecasts.

Once the market became involved in the implementation of monetary policy, it would probably lead to further market reforms of the monetary system.As noted earlier, some critics argued that the early “free banking” proposals hadfailed to demonstrate that a regime of private currency issuers would necessarilylead to price stability. Several decades ago Barro (1982, p. 110n) expressed thefollowing skepticism about free banking:

“Another possibility, which I have not given attention to in this paper,involves removing the government from the money-issue business. Media of

exchange would then be provided entirely by private entities. The workings of a private, noncommodity monetary system are not well understood (at least byme).”

Glasner (1989), Woolsey (1992) and Dowd (1993, 1996) showed thatindex futures offered a way of pinning down the (expected future) price level, andthus removed the biggest roadblock to free banking. Once index futures targeting became well established, there would be less resistance to allowing private banksto issue currency—so long as that currency was also redeemable into a standardindex futures contract. Sudden abolition of the Fed is politically infeasible,instead it is more likely to gradually “wither away” as more and more of its

functions are performed by market entities.This is not the first paper to consider a market-oriented monetary policy

regime. Many of the previous proposals, however, failed to adequately address anumber of practical issues such as the ‘end of period problem’ and the ‘circularity problem’. More importantly, these papers did not provide a convincing argumentfor why monetary policy could be implemented most effectively with adecentralized market-based approach. In this paper I have focused less on thetechnical aspects of a market-oriented policy, and more on the conceptualadvantages of this approach. As a practical matter, it is the highly unconventionalnature of this sort of regime that is likely to be the biggest barrier to its adoption.Thus it might be useful to conclude with a brief discussion of some factors that

point in the direction of further market reforms in the monetary arena.Recent trends in world history provide a powerful argument for taking

seriously any proposal for a market-oriented public policy. Since 1980, the worldhas seen a revolution in policymaking at two levels. In the arena of microeconomic regulation, there has been a powerful world-wide trend toward

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privatization and deregulation. Paralleling the neoliberal trend in government policymaking has been an equally dramatic change in macroeconomic theory and policy. Since the 1980s, older Keynesian models have been replaced by “new

Keynesianism”, in which the focus of policy has shifted toward maintaining a lowand stable inflation rate, and perhaps also reducing the output gap. One of themost important innovations in these newer Keynesian models is the increasedfocus on market expectations. Expectations are assumed to be rational and theimpact of policy depends not just on the current setting of the policy instrument, but also on the expected future time path of that variable. All of these changes intheory and policy make monetary policymaking fertile ground for the sort of innovations that harness the information from newly created policy markets.

As expectations have begun to play a more important role in economictheory, we have also seen a dramatic increase in the sophistication of financialmarkets. We already have futures markets for the fed funds rate, and the spread

between nominal and indexed bond yields provides a crude estimate of marketinflation expectations17. In the future we can expect to see the creation of moreand more explicit or implicit macro futures markets.

Looking further ahead, technological innovations will eventually lead toeven more basic policy innovations. For instance, the replacement of cash bysmart debit cards will allow for the payment of interest on cash balances. Thiswill reduce one of the drawbacks associated with Hall’s inflation targeting proposal, the fact that only bank reserve holders would be able to conveniently participate in the policy process. Improvements in information technology mayalso allow for estimation of the price level in real time18. Such data would allowfor the creation of a “spot CPI” which would enhance the prospects for the sort of

indirect convertibility regime proposed by Greenfield and Yeager (1989.)19 While the precise path of reform is obviously highly uncertain, the general

direction of policy innovation seems almost inevitable given the twin trends of increasing financial market sophistication and the increased emphasis on marketexpectations in economic theory and policymaking. And even if the specificreforms suggested in this paper never come to pass, consideration of optimalmonetary policy regimes can improve our understanding of the essential problems

17 Craig (2003) showed that the inflation forecast implicit in this interest rate spread may becontaminated by a time-varying risk premium.18

Note that this would not require real time estimates of all prices, but only the much smaller subset of prices currently measured by government statisticians. Given the extensive real timedata already available to large retailers such as Walmart, such a possibility may arise sooner thanmany imagine.19 Even with the overall price level available in real time, a feasible indirect convertibility regimewould require that the price level include a non-trivial subset of completely flexible prices, such ascommodity prices.

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faced by policymakers, and may indirectly lead to other, more practical, policyinnovations.

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Let a Thousand Models Bloom the Advantages of Making the FOMC a Truly 'Open Market