Expectations are critical to understanding the economy and developments in the financial system.  Of course, we look at a great deal of data from the nonfinancial side of the economy, such as gross domestic product (GDP) growth, the unemployment rate, and changes in the prices of goods and services.  These data certainly reflect expectations but not always in a transparent way.  And, these data take some time to compile and so are never available in real time.

Because financial asset prices embody expectations about the future, they also contain forward-looking information about prospective developments, and many are available continuously and instantaneously.  We pay attention to an extensive range of asset prices, including those of Treasury securities (both nominal and real), corporate debt and equities, and derivatives.  Although it is not easy, we use these asset prices to tease out information about expectations that help us to interpret and predict the pace of economic activity and prices.

But at this point, it seems to me there is no, my judgment, no pressing need for any immediate action {in response to the drop in the stock market}. There is a lot of stability in the market responses themselves. Just for example, should it turn out, this is not a forecast by any means, but should it turn out that the economy is weaker than the prevailing baseline forecasts that I talked about, then you'll see interest rates in general declining in anticipation of future Federal Reserve action, and that will help to stabilize the economy and prevent the weakness from developing into a serious matter.

In comments to reporters after his speech, as reported by Bloomberg News

In my opinion, there has been a discrepancy lately between the views of the FOMC members, as summarized in the Committee’s public statements, and the views of many financing market participants.  Although there is a wide range of views in the market, some participants have jumped to the conclusion that monetary policy will be eased in the near future.  Surveys of financial market economists show that many expect an easing in monetary policy sometime this year.  In addition, the yield curve and financing futures prices incorporate some expected easing of monetary policy later this year.

In contrast, the FOMC has continued to express its concern about upside inflation risks. After its last meeting on December 12, the FOMC stated that “some inflation risk remain” and that “the extent and timing of any additional firming” would depend on how incoming data affected the outlook for growth and inflation.  

In my view, the easing of monetary policy that market participants expect would be appropriate only if inflation clearly subsided from recent elevated levels, and if the incoming data implied the inflation outlook would remain favorable in the future.  In my judgment, it is premature to conclude that current conditions define a clear path for policy.

On Fed expectations discounted by markets:   "I've never fully understood what the case was the markets saw of why there would be such large and early rate" reductions."

"Many forecasters have been perplexed by the view of the future of rates that seemed to be embodied in the fed funds curve,'' she said, referring to interest-rate futures.

From audience Q&A, as reported by Bloomberg News

On the bond market's expectations for lower rates in 2007:

``Our job is not to satisfy markets. Our job is to get the economy right.''

From Q&A session, as reported by Bloomberg News

Eurodollar futures have an accuracy rate of less than 30 percent since 1994 in forecasting the target rate for overnight loans between banks six months later, the St. Louis Fed said in an August study...  ``Those are the best forecasts we have, but they're simply not very accurate at the end of the day,'' Poole said in an interview last week.

Prices on federal funds futures and Eurodollar futures suggest that market participants expect the FOMC to cut the target federal funds rate about 50 basis points during 2007, a view consistent with expectations of a "soft landing." At the same time, market-based options prices on these interest rate futures indicate that implied volatilities are quite low, suggesting a surprising degree of certainty regarding policy expectations. Taken at face value, market participants appear to be reasonably certain of a benign outcome for both economic growth and inflation. In contrast, my own judgmental forecast includes a wider range of possible outcomes than is implicit in these market-based measures.

Our own policies and actions affect market prices. As a result, when we look to financial markets for information, the information we seek may be shaped in part by our own views. The more that "market information" reflects our own actions, the less it is useful as a source of independent information to inform our policy judgments.

We need to be alert to this "mirror problem," in which markets can cease to provide independent information on current and prospective financial and economic developments. In the extreme case, financial markets keenly follow the Federal Reserve, the Federal Reserve is equally attuned to the latest financial quotes, and fundamentals of the economy are obscured. Under such circumstances, asset prices might teach us only about our skills as communicators.

Interest-rate expectations reflect investor understanding of how rates will evolve, which is why an inverted yield curve has often preceded business cycle peaks. But the market’s rate expectations also depend importantly on the market’s read of what the FOMC will do. If the market’s expectation does not match the FOMC’s own expectation, then policymakers need to do some soul searching.

This systematic, consistent approach has enhanced the ability of financial markets to anticipate the Fed's response to economic developments and to respond themselves in advance of the Fed.

Under the forecast-based approach, in contrast, the public will generally find inferring the likely course of policy to be a great deal more difficult. In that regime, policy plans depend in a complex way on policymakers' outlooks, risk assessments, and objectives, which the public is unlikely to deduce accurately without guidance. Clear communication thus appears to be especially important for central banks that employ a forecast-based approach to policy--a category that includes most contemporary central banks, including the Federal Reserve.

[O]pen and clear communication by the policy committee--which in practice includes speeches and congressional testimony by FOMC members, as well as official statements--makes monetary policy more effective in at least three distinct ways.

First, in the very short run, clear communication helps to increase the near-term predictability of FOMC rate decisions, which reduces risk and volatility in financial markets and allows for smoother adjustment of the economy to rate changes...

Second, in the long run, communicating the central bank's objectives and policy strategies can help to anchor the public's long-term expectations--most importantly, its expectations of inflation...

The third way in which clear and open communication enhances the effectiveness of monetary policy--the channel that will be the focus of my remarks today--is by helping to align financial-market participants' expectations about the future course of monetary policy more closely with the policy committee's own plans and projections. As I will discuss, to the extent that central bank talk provides useful guidance to markets about the likely future path of short-term interest rates, policymakers will exert greater influence over the longer-term interest rates that most matter for spending decisions. At the same time, expanding the information available to financial-market participants improves the efficiency and accuracy of asset pricing. Both of these factors enhance the effectiveness and precision of monetary policy.

To be absolutely clear, in pointing out the benefits of clear communication I am not asserting that central bank talk represents an independent tool of policy. Indeed, if the central bank's statements are not informative about the likely future course of the short-term interest rate, they will soon lose their ability to influence market expectations. Rather, the value of more-open communication is that it clarifies the central bank's views and intentions, thereby increasing the likelihood that financial-market participants' rate expectations will be similar to those of the policymakers themselves--or, if views differ, ensuring at least that the difference can not be attributed to the policymakers' failure to communicate their outlook, objectives, and strategy to the public and the markets.

The formation of market expectations about the economy as it relates to policy choice by the Federal Open Market Committee has the following three properties: There are a few (usually two) likely choices for the policy outcome of an FOMC meeting. The announcement of the policy action is usually fixed in time (with the rare exception of intermeeting moves). Some members of the private sector are viewed as experts in divining policy intention. These conditions are precisely the ones found in models of information cascades, in which investors defer to received wisdom about a likely action and fail to use their private information efficiently (as in Bikchandani, Hirshleifer, and Welch, 1992). Why policymakers should feel obliged to validate expectations based on the actions of traders who are taking positions because other traders who read something in the newspaper are also doing so is not obvious.

I indicated earlier that I would counsel against moving today, for if we do, in my judgment we will break whatever developing pattern for equity price stability may be currently emerging, at least temporarily. Were we to cut rates, there doubtless would be an initial sharp rise in stock prices as less sophisticated buyers enter the market.  However, a move today would remove the constructive ambiguity about monetary policy from the markets. As a consequence, after the initial price surge the more sophisticated traders could well be selling, with a distinct possibility that stock prices would fall markedly, essentially undercutting the nascent stabilization that may be in the process of forming. We would have used up some significant monetary policy ammunition without realizing any short-term stabilizing benefits. Long term, of course, it doesn’t matter much unless the failure of achieving short-term stability sets us on a path with long-term consequences.

To repeat, we have a credible intermeeting window over the next 10 days. Let us employ the time to monitor markets, but especially to look for evidence of emerging stability in capital goods orders. I might say in closing that I know all of you in the Reserve Banks will be working on Beige Book commentary shortly. And I would request that you make a special endeavor to see if you can gain some insights on what is going on in capital spending within your Districts and what the prospects are for a stabilization and hopefully an upturn.