Thank you to the conference organizers for inviting me here to discuss what former Chair Bernanke has famously referred to as a "hall of mirrors" problem: a situation in which a central bank's reaction function and financial market prices interact in economically suboptimal and potentially destabilizing ways. In my remarks today, I will lay out the way I think about the interplay between financial markets and monetary policy, with a focus on how I myself seek to integrate noisy but often correlated signals about the economy that I glean from models, surveys, and financial markets.
Three Observations
I begin with three unobjectionable observations. First, because of Friedman's long and variable lags, monetary policy should be-and, at the Fed, is-forward looking. Policy decisions made today will have no effect on today's inflation or unemployment rates, so good policy needs to assess where the economic fundamentals are going tomorrow to calibrate appropriate policy today. Of course, financial markets are also forward looking. An asset's value today depends upon its expected future cash flows discounted by a rate that reflects the expected path of the policy rate plus an appropriate risk premium.