Optimal Policy and Market-Based Expectations

Financial market prices contain valuable information about investors ’ views regarding future interest rates, inflation, and other economic variables. 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. People’s expectations for future income, interest rates, and inflation are important determinants of financial and economic outcomes. But these expectations are not observable. Surveys of the public or economic forecasters can provide some guidance, but they are published only monthly at best. Statistical estimates based on historical data are also useful but are subject to considerable model uncertainty. A popular alternative is to use financial market prices to infer investors ’ expectations. For example, the breakeven inflation (BEI) rate, which is the difference between nominal and inflation-adjusted bond yields, provides a measure of market-based expectations of future inflation. However, market-based 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. Fluctuations in risk and liquidity premiums and in other market forces complicate how market-base