Eyes on the prize: the role of expectations in monetary policymaking.

• Author: Clarida, Richard H.
• Position: Awards list

When most people think about October, they think about football games on crisp weekend afternoons or perhaps the World Series. But this time of year, as during every October, economists are also trading opinions on the winners of the Nobel Prize in economics. The prize for 2011 was awarded to Tom Sargent of New York University and Chris Sims of Princeton University. Upon hearing the news, my immediate reaction was a resounding "Well, it's about time!" Sargent and Sims, working contemporaneously but mostly independently, developed in the 1970s and 1980s the empirical and statistical tools that economists and policymakers use daily to study and estimate the impact of monetary and fiscal policy actions on the economy and on financial markets---aware they are functioning in a world in which firms, investors, and households are also making forecasts of those policy actions.

Sargent and Sims were also early to recognize the importance of, and the potential pitfalls arising from, monetary and fiscal policies that depend upon policymakers themselves forecasting those private sector forecasts in setting a path for interest rates or government spending. If forecasting the forecasts of others sounds circular, that's because it can be, and as a result the mathematics are not always easy (think "fixed point theorems for compact sets over countable states of nature"). But Sargent and Sims, along with previous Nobel prize winners Robert Lucas and Ed Prescott, developed the framework, really the paradigm, that economists use today. This framework offers crucial insights into recent central bank actions--and market responses.

SHAPING MARKET EXPECTATIONS

The world's major central banks certainly use Sargent's and Sims's methods for estimating and evaluating "old normal" monetary policies that set a path for the short-term interest rate to hit an inflation target. From their results, we know private sector expectations of this policy path for interest rates are crucial to macroeconomic outcomes and thus to the success--or failure--of the policy.

So when we hear central bankers today talking about extended periods or measured paces, they are channeling Sargent and Sims (via Michael Woodford, Sims's one-time colleague at Princeton), using forward guidance to reinforce and, in practice, often shape market expectations that will lead to desired outcomes for inflation and unemployment. The Fed boldly deployed this approach in its August 2011 statement:

"The...