Sunday, June 04, 2006

Could the market set short term rates better than the Fed?

An article in today's Business Week online includes this paragraph.
Wall Street will ultimately continue drifting until the Fed gives a definitive stance on the economy, inflation, and its rate tightening.
Because the Fed sets short term interest rates, we often have paragraphs like this, wondering what the Fed will do. I wonder what would happen if the market were allowed to set its own rates. Suppose there were some means (see below for one suggestion) whereby the market could "vote" on short term interest rates. Since low rates are good for the economy (and hence the stock market), one might suppose that the market would "vote" for low rates. But since rates that are too low lead to an overheated economy and inflation, which is bad for the market and the economy, the market won't want rates that produce that effect. It's currently the Fed's job to get it right: sustain the economy but keep inflation in check. We now know that market mechanisms are often better than expert opinion about this sort of decision. If given a chance would the market be a better rate setter than the Fed?

Of course even if the market were allowed to set its own rates, we would not have any better idea of where rates were going than we do now. Just as we don't know what the stock market will do tomorrow, we also wouldn't know what the market's decision about short term rates will be tomorrow.

Here's a neat way to let the market set its own rates. Establish futures and option markets for short term interest rates. Then the public could "bet" on what rates the Fed will set. Let the Fed retain the authority to set rates, but let it also (perhaps in secret) establish a policy of setting the rate at whatever the future and option markets predict! As long as the market believes that the Fed will act to set the best or most appropriate rate given the current state of the economy, it will "predict" whatever rate it thinks is best!

What would happen if the policy of setting the rate according to the market were made explicit? One danger would be market manipulation. People betting on a particular rate would attempt to make the rate conform to their guesses. A possible way to blunt that risk is to let the payoff depend on a smoothed average of the predicted rate. It is much harder to significantly manipulate a smoothed average than an instantaneous price.

This deserves more thought. It would be fascinating if we could create a mechanism that allowed the market to set the rate it thought was best that at the same time was protected from being gamed for personal gain.

1 comment:

r. weber said...

Counterproductive in current form, but worthy of further discussion, refinement & experimentation. Main problem is that aggregation of ignorance over time does not regress to enlightment, even when a running tally is explicitly displayed as with on line polling. Unfortunately, using internet connectivity to solicit and record unfiltered public opinion merely amplifies ignorance.

One needed improvement is to set a requirement for participation in the virtual market or voting process according to a similar rationale society uses to exert some control over who may drive an automobile. Just as with the driver's license, the participants in the voting process must pass a competence test--in this case a basic understanding of macro & micro economics. Just as we have privately run schools for drivers' training, the private sector would be allowed to create schools for "voters training." Successful experimentation with this concept for the Fed interest rate decision could lead to a constitutional amendment to institute a fairer and more rigorous form of the "literacy test" once used in southern states as a requirement for voting in political elections. Given the recent deterioration of quality in political debate and election of criminally corrupt representative to government at the state and federal level, there should be two levels of citizenship where voting rights are restricted to an educated class of citizens who have demostrated competence in discriminating various forms of propaganda and understand the basics of science, economics, and history. In my view the test should be similar in difficulty to that administered for college entrance, but I'm open to some latitude for setting the threshold.