Market-based expectations can offer a great deal of data for policymakers, but they have limitations and can be difficult to interpret since prices are affected by factors other than those of interest to policymakers, according to a Federal Reserve Bank of San Francisco
"Financial market prices contain valuable information about investors' views regarding future interest rates, inflation, and other economic variables," according to Michael D. Bauer, an economist with the San Francisco Fed, and Glenn D. Rudebusch director of research and executive vice president in the Economic Research Department at the Fed. "However, such market-based expectations can be hard to interpret because changes in risk and liquidity premiums also affect asset prices. In practice, policymakers should be cautious in relying on the expectations information in market prices."
While individuals' beliefs about future income, interest rates, and inflation will impact the economy, they cannot be quantified. "Surveys of the public or economic forecasters can provide some guidance, but they are published only monthly at best," the writers say. "Statistical estimates based on historical data are also useful but are subject to considerable model uncertainty."
Using financial market prices to project investors' expectations "do not correspond exactly to real-world expectations because asset prices also reflect the compensation that investors require for making risky and somewhat illiquid investments."
Also, "fluctuations in risk and liquidity premiums and in other market forces complicate how market-based expectations are interpreted and used by policymakers - including central bankers."
The authors suggest distinguishing between "real-world" and "market-based" expectations. Real world expectations are defined as those "based on the standard 'true' probabilities of everyday interpretation," while market-based are strictly figured through prices in financial markets. Statistical models are used to calculate real world expectations.
"International financial developments were probably an important factor in driving down U.S. BEI (breakeven inflation) rates over the past year," according to the authors. Therefore, "a strict, mechanical reliance on these changes in BEI rates to set U.S. monetary policy would seem unwise."
