Fed Reaction Function Debate Ignites Controversy Over Market Influence

Kevin Warsh, Chairman of the Federal Reserve, has been criticized for refusing to publicly articulate the Fed's monetary policy reaction function. Critics argue that without this information, markets will do a poor job anticipating monetary policy and financial conditions will adjust more slowly.

The critics' argument is based on the idea that modern monetary policy requires a well-communicated reaction function. However, economists Stephen Morris of Princeton and Hyun Song Shin at the Bank for International Settlements have developed a theoretical challenge to this assumption.

According to Morris and Shin, the Fed has two potentially conflicting relationships with financial markets: it uses markets to influence the economy and it uses market prices to learn about the economy. The more successfully the Fed imprints its own expectations on market prices, the less independent information those prices may contain.

This is known as the 'reflection problem.' Morris and Shin argue that a reaction function can create this problem, not solve it. They model a central bank that announces a state-contingent reaction function and find that excessive reliance on market signals becomes self-defeating.