Contributions to Macroeconomics

Volume 6, Issue 1 2006 Article 8

Let a Thousand Models Bloom: The

Advantages of Making the FOMC a Truly
‘Open Market’
Scott Sumner∗

∗
Bentley College, ssumner@bentley.edu

Copyright 2006
c The Berkeley Electronic Press. All rights reserved.
 Let a Thousand Models Bloom: The
Advantages of Making the FOMC a Truly
‘Open Market’∗
Scott Sumner

Abstract
In recent decades there has been a worldwide shift toward market-oriented economic policies,
sometimes termed ‘neoliberalism’. In the policy arena this trend has been most apparent in the
widespread move toward privatization and deregulation. And in the academic world there has
been increased respect shown to free market ideologies, even to policy views that would once have
been regarded as impractical. Surprisingly, monetary policy is one area that has been relatively
unaffected by the neoliberal revolution. Not only have governments retained a monopoly on fiat
money, but even some free market ideologues have been skeptical of proposals for laissez-faire
monetary regimes. This paper will show that market forces can greatly improve the effectiveness
of monetary policy.

I will argue that the Federal Open Market Committee (FOMC) should do no more than set the
goals of monetary policy. Sumner (1989, 1995) and Dowd (1994) argued that the creative use of
prediction markets for goal variables might allow central banks to more accurately target variables
such as inflation. I will briefly review the literature on policy futures markets, examine Bernanke
and Woodford’s (1997) critique of policies that “target the forecast”, and then suggest some im-
provements in previous reform proposals.

More importantly, I show that policy future markets can address some of the key weaknesses
of orthodox macroeconomic theory and policy, particularly the lack of consensus over structural
models. Under this sort of policy regime, open market operations would reflect the views of not
merely 12 individuals, but rather the consensus opinion of all those who choose to engage in open
market operations. Even an issue as basic as the optimal monetary instrument would no longer
be determined by the monetary authority, instead, each individual participant in the policymaking
process would choose their own policy indicator. I will also show that a universal FOMC can
improve the effectiveness of monetary policy even if the average level of decision-making skills
on the expanded FOMC is inferior to the average skill level of the current 12 members.

KEYWORDS: monetary policy

∗
Address: Department of Economics, Bentley College, Waltham, MA 02452. I would like to
thank Aaron Jackson and two referees for helpful comments and suggestions.
 Sumner: Let a Thousand Models Bloom: Making the FOMC an 'Open Market'

In recent decades there has been a worldwide shift toward market-oriented

economic policies, sometimes termed ‘neoliberalism’. In the policy arena this
trend has been most apparent in the widespread move toward privatization and
deregulation. And in the academic world there has been increased respect shown
to free market ideologies, even to policy views that would once have been
regarded as impractical. Surprisingly, monetary policy is one area that has been
relatively unaffected by the neoliberal revolution. Governments have retained a
monopoly in both the production of fiat money, and the implementation of
monetary policy.
This paper has two primary objectives. First, to show that even where
governments retain a monopoly in the production of currency, a market-oriented
system of open market operations can greatly improve the effectiveness of
monetary policy. In section 4 I show that despite recent arguments to the
contrary, market forces can be introduced into monetary policy by creating a
regime based on index futures targeting. Then in section 5 I suggest a few
technical improvements to previous proposals for monetary regimes where open
market operations are conducted using index futures.
The second objective is to provide several new arguments for adopting a
market-oriented monetary policy regime. Section 3 examines a key weakness of
conventional monetary policies, the inability of macroeconomists to agree on the
appropriate instrument of monetary policy. This provides one important
motivation for the index futures targeting regime discussed in sections 4 and 5,
which doesn’t force policymakers to choose any particular policy instrument.
And then in section 6 I discuss how recent research in prediction markets provides
powerful new arguments for introducing market forces into monetary
policymaking. I conclude by arguing that an index futures-based monetary
regime could be the first step toward broader reforms in our monetary system.
But first we need to briefly examine why it has proven so difficult to incorporate
market reforms into monetary policy.

2. Why Don’t We Have Laissez-faire Monetary Regimes?

During the 1970s and 1980s a number of suggestions were offered as to how the
government might be removed from the monetary arena, most famously Hayek’s
(1976) proposal for “competition in [fiat] currency.” Many of the early proposals
were explicitly motivated by the perceived failures of government run fiat money
regimes, particularly the high and variable inflation rates experienced between the
mid-1960s and the early 1980s. More recently, however, most central banks have
been able to deliver relatively low and stable rates of inflation, thus lessening the
perceived need for radical policy reforms. Advocates of laissez-faire monetary
arrangements currently face at least two major hurdles in convincing others of the

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desirability of scrapping central banks and plunging into the uncertain world of
privately issued currencies.
The first hurdle is to show that private currency issuers have both the
ability to discover the proper goals of monetary policy, and the incentive to
implement such a policy. Although competitive markets are often a marvelously
effective “engine of discovery”, the money market presents some extra
complications not present in other goods. Proposals for optimal monetary
regimes often begin by considering policies from a consumer welfare perspective,
as in Friedman (1969). Unfortunately, because money is the “numeraire” by
which other prices are specified, and because many wages and prices are “sticky”,
changes in the real value of money can also impact employment and output.
Given the myriad ways in which monetary instability can affect economic
welfare, can we be sure that the type of currency preferred by consumers would
also be socially optimal? Or does wage and price stickiness cause monetary
policy to have “external effects”?
Presumably an ideal monetary policy would deliver something close to
price stability. But there remain significant differences among macroeconomists
as to precisely what form of ‘price stability’ is optimal. For instance Hayek
(1987, p. 388) suggested stabilizing money in terms of “a defined index number”,
Thompson (1982) favored stabilizing an aggregate wage index, whereas Hall
(1986) advocated an “elastic price index”, i.e. minimizing a weighted average of
price level and employment fluctuations. Of course advocates of central bank
monetary policies must also justify their preferred policy goal; but the advocate of
laissez-faire faces an even greater challenge, showing why private currency
issuers would have an incentive to aim for the price level path most likely to
produce macroeconomic stability.
The second hurdle relates to policy implementation. How closely would
the actual price level under laissez-faire follow the time path preferred by private
currency issuers? Even with the best of intentions, it is not obvious that a
decentralized system of private currency issuers would be able to effectively
overcome the difficulties created by the various policy lags. It should be
emphasized that none of these hurdles are necessarily insurmountable, indeed
White (1987) and Dowd (1996) present some powerful arguments in favor of this
type of monetary arrangement. However, with even free market economists such
as Barro (1982), Hall (1986) and Friedman (1987) shying away from complete
laissez-faire in money, it appears that reform will need to proceed in a piecemeal
fashion. In section 7 I explain how the reforms discussed in this paper might
actually facilitate the implementation of other reform proposals, such as free
banking.
During the late 1980s and the 1990s much useful work continued to be
done on topics such as free banking, indirect convertibility, and index futures

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targeting. In section 5 I discuss how this work relates to the proposal developed
in this paper. Unfortunately, an important paper by Bernanke and Woodford
(1997) challenged what I believe is the most promising way of bringing market
forces into monetary policymaking, index futures targeting. In the nine years
since the Bernanke and Woodford paper was published, there has been relatively
little progress in research on market-oriented monetary reforms. Instead, most of
the research on monetary policy has been in the new Keynesian tradition—with a
focus on developing policy rules for central banks, such as inflation targeting or
the “Taylor rule.”
Today there is a need for proponents of market-oriented monetary reforms
to do a better job of addressing the issues of greatest concern to orthodox
macroeconomists. In the next section I discuss a major flaw in orthodox
monetary economics, the fact that policy proposals assume a “consensus model”,
even though there is still no consensus regarding issues as basic as the
transmission mechanism for monetary policy. This will then be used to motivate
the market-oriented policy developed in sections 4 and 5.

3. Why are there So Many Different Approaches to Monetary Economics?

One fairly standard approach to monetary economics is to write down a structural

model of the economy, and then compare the performance of various monetary
policy rules in that hypothetical economy. McCallum (2002) suggests that we
don’t know the “true” model of the economy, and he advises looking for robust
policy rules, that is, policies that perform relatively well under a wide variety of
structural assumptions. The market-based policy discussed in sections 4 and 5
will take this eclectic approach to its logical conclusion. Monetary policy would
reflect the decisions of thousands of market participants, each using their own
structural model. Because model uncertainty is such an important motivation for
this proposal, we need to examine this problem more closely.
The questions we need to address are: Is there a consensus model for use
in monetary analysis? If not, why not? And what are the prospects for
developing such a model in the near future? Blanchard’s (2000) survey of
macroeconomics during the 20th century takes what is sometimes referred to as a
“Whig” view of the history of economic thought, with the field of
macroeconomics exhibiting relatively steady progress toward better and better
models of the economy. Friedman (1975) takes a more skeptical view, arguing
that the core theoretical innovations mostly relate to our better understanding of
the distinction between a change in the price level and a change in the rate of

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 Contributions to Macroeconomics , Vol. 6 [2006], Iss. 1, Art. 8

inflation.1 During the 1960s and 1970s (after most countries adopted inflationary
fiat money regimes) economists did develop a greater understanding of the
distinction between real and nominal interest rates, and how changes in inflation
expectations can shift the Phillips Curve. These insights about the impact of
policy on expectations led to a series of theoretical innovations that culminated in
the Lucas Critique.
The rational expectations revolution clearly improved our understanding
of aggregate supply, particularly when compared to earlier Phillips curve models.
In this paper, however, we are concerned with the implementation of monetary
policy, not the proper goals of policy. That is, the question is how to best control
aggregate demand, not what is the proper level of aggregate demand.
Unfortunately, there is as yet no consensus about how to model the money supply
transmission mechanism, nor is there agreement as to the proper instrument of
monetary policy. Consider the policy views of these five distinguished monetary
economists:

1. Michael Woodford—Favors policy rules with interest rate instruments aimed

at stabilizing the price level. Recent work is perhaps closest to a “consensus
model”.

2. Bennett McCallum—Favors policy rules with a monetary base instrument

aimed at stabilizing nominal GDP growth.

3. Milton Friedman—Favors steady growth in broader monetary aggregates such

as M2.

4. Robert Mundell—Favors fixed exchange rate regimes.

5. Robert Hall—Advocated a price level targeting scheme involving interest

bearing bank reserves. Higher rates on reserves would lower demand for
reserves, and thus raise the price level. Hall (1982) also proposed monetary
policies aimed at targeting the price of a specified basket of commodities.

What is most interesting about the preceding list is not that each economist
has their own preferred approach to monetary policy, but rather that these policy
recommendations are based on fundamentally distinct ways of thinking about
monetary economics in general. Even more striking is that this diversity exists
among economists who in many ways are right in the mainstream—none of the

1
In discussing the Phillips curve issue, Friedman (1975, p. 177) argued that “As I see it, we have
advanced beyond Hume in two respects only: first, we now have a more secure grasp on the
quantitative magnitudes involved; second, we have gone one derivative beyond Hume.”

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five are ‘traditional Keynesians’ who deny that the long run aggregate supply
curve is vertical, nor do any adopt the extreme New Classical position of
complete wage and price flexibility in the short run. How can we explain this
diversity?
To begin at perhaps the most basic level; it is not clear that the preceding
five economists would even agree on what is meant by the term ‘monetary
policy’. Friedman and McCallum might argue that at its essence, monetary policy
is control of the quantity of money, however defined. Mundell (2000) and Hall
might argue that monetary policy is basically a change in the price of money (in
terms of foreign exchange, or gold, or a basket of commodities). Woodford
represents the mainstream view, which sees monetary policy in terms of changes
in the rental cost of money, i.e. short term interest rates.
It should be obvious to anyone who follows the debate over monetary
policy that these various perspectives strongly influence economists’ policy
recommendations. One need only examine the recent debate over the Japanese
“liquidity trap” to see a striking confirmation of the link between how economists
approach monetary analysis, and what sort of policies they recommend. A
monetarist who focuses on the relationship between the quantity of money and the
price level would not see a zero interest rate as being a constraint on policy. They
would recommend a policy of monetary expansion, or “quantitative easing”,
which would raise Japan’s expected future price level and thus reduce the current
level of real interest rates. Eggertsson and Woodford (2003) also saw
expectations as a key to understanding the liquidity trap, but doubted the efficacy
of quantitative easing. Instead they favored policy options such as committing to
hold nominal interest rates at zero until some time after Japan had exited from the
liquidity trap. A third group has taken a “price of money” approach to policy,
arguing that Japan should depreciate the yen against other currencies2.
In this section I have mentioned only a few of the areas in which
different approaches to monetary analysis lead to different policy views.
Monetary economists also differ in their views of the relative importance of
money illusion, wage stickiness, and price stickiness in the aggregate supply
function. They differ in their views of what causes short run price stickiness3. In
fact, there isn’t even any general agreement as to what one means by “the” price
level. Is it the average price of newly-produced consumer goods, or should it
include many other assets such as the stock of existing capital goods? Each area
of disagreement has a multiplicative impact on the total number of potential
model permutations. Given this complexity, it is unlikely that any two prominent
macroeconomists have precisely identical views as to how best to model the
macroeconomy.
2
See Svensson (2003b).
3
McCallum (2002, p. 84-85, ft.) lists ten different models of short run price stickiness.

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Of course it is human nature to think one’s own views are best, and that
other economists can eventually be persuaded to see the light. But for policy
purposes, it is also important to be realistic about the degree of consensus that the
field of monetary economics is likely to reach in the near future. All of the
perspectives mentioned above, the quantity, price, and rental cost approaches to
policy, as well as the short run sticky-price and long run classical frameworks, go
back at least two centuries. It is not obvious what sort of empirical findings, if
any, could determine who’s right and who’s wrong, or indeed whether any single
approach is optimal under all circumstances. The most important motivation for
this paper is the need to develop a monetary policy regime that is robust to not
just a handful of structural models in the new Keynesian tradition, but to virtually
any mainstream approach to monetary economics.
The recent dispute over Japanese policy options suggests that mainstream
economists have failed to reach a consensus over questions as basic as what
constitutes the appropriate instrument of monetary policy. The policy proposal
discussed in the following two sections sidesteps this problem in a quite elegant
way; we will develop a policy regime that lacks any policy ‘instrument’—at least
in the conventional sense of that term. Nor is there any need for policymakers to
agree on the appropriate structural model of the economy.

4. What Would a “Market-Oriented” Monetary Policy Look Like?

In the next two sections we will assume that the Federal Open Market Committee
(FOMC) focuses solely on establishing the goals of monetary policy. The actual
implementation of policy would be opened up to the general public, with open
market operations reflecting the views of not merely the 12 individuals who
happen to be serving on the FOMC, but rather the consensus opinion of the
market as a whole. In section 5 I examine some of the practical problems
associated with constructing this type of policy regime. Then in section 6 we will
see how competition can improve the effectiveness of monetary policy, even if
the average level of decision-making skills on an expanded FOMC is inferior to
the average skill level of the current 12 members.
In order to develop a market-oriented monetary policy we first need to
think about how we can induce market participants to make socially constructive
decisions, i.e. to engage in open market purchases or sales that are expected to
reduce the deviation of the monetary goal variable(s) from its target value. For
our purposes, the term ‘market-oriented’ will refer to a regime where there is free
entry, and participant rewards are positively correlated with the (social)
productivity of their activities. The ‘free entry’ part is relatively easy to explain—
all individuals and institutions would be allowed to undertake open market
operations. The issue of how to reward monetary policy participants is much

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more complex, and we will begin by considering how the current FOMC might
reward individuals for their decisions, or more precisely, their contributions to
“the” decision.
It turns out that there is a relatively simple way of rewarding monetary
policy decision-makers. For instance, assume that under the current policy
regime the Fed has a 2% inflation target for the next 12 months, and that the
committee uses a median voter procedure to set the fed funds rate target at 4.5%.
Then the six (hawkish) FOMC members who advocated a fed funds target above
4.5% will presumably be concerned that the lower actual instrument setting will
prove to be too expansionary, and will push the inflation rate above 2%. The six
dovish FOMC will presumably have the opposite expectation.4 In that case, one
could link part of each FOMC members’ salary (for that meeting) to the realized
inflation rate over the following 12 months. If actual inflation turned out to be
above the 2% target, then the hawkish members would receive a higher salary,
and vice versa. But if we contemplate extending the “one-person-one-vote”
procedure to all 300 million Americans, we would need to confront the fact that
most people are extraordinarily uninformed about monetary policy.
It is generally assumed that markets aggregate information most
efficiently if prices are determined on a “one-dollar-one-vote” basis, rather than
one-person-one-vote. In that case, one could imagine the central bank setting up a
CPI futures market where all trades are contingent on the setting of the monetary
policy instrument. Using the aforementioned policy goal, the CPI futures
contracts would have a par value of (1.02)*(current CPI). Traders who expected
higher than target inflation would take a “long” position, and vice versa. As in the
market for Treasury bills, this would be a contingent auction with each trader
filling out an offer sheet listing their preferred long or short position at various
policy instrument settings. In this case, the only trades that would be executed
would be the offers that were contingent on the actual setting of the policy
instrument. And that instrument setting would be the value that most nearly
equilibrated the short and long positions in the CPI futures market. For example,
CPI futures long and short positions might be most nearly equalized on contracts
contingent on a 4.25% fed funds rate target. In that case, at higher potential
instrument settings (tighter money) shorts would have exceeded long positions
whereas at instrument settings below 4.25% the long positions would have
exceeded the shorts5.
The CPI futures approach certainly brings the market much more deeply
into the monetary policymaking process. If markets are efficient, or more

4
Of course this is only true if there is a generally agreed upon policy goal (2% inflation in this
case). When we move to a market-oriented regime, the strict separation between decisions about
the goals of policy, and how best to implement those goals, will become much clearer.
5
Sumner (1997) discussed a similar proposal.

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precisely if the market price of CPI futures is equal to the optimal forecast, then
this system would represent an ideal form of the “forecast targeting” advocated by
Svensson (2003a), and others. Unfortunately, this system would require a
cumbersome apparatus where each participant in the market makes a set of offers
that are each contingent on various settings of “the” policy instrument. More
importantly, even if this type of policy regime improved the effectiveness of
monetary policy (by reducing the volatility of inflation), it doesn’t address one of
the fundamental issues raised in section 3, the lack of consensus as to the optimal
policy instrument. Should the policy instrument be the fed funds rate, the
monetary base, or the price of foreign exchange? And as we have seen, this
question is most likely to arise in precisely those situations where effective
monetary policy is most needed6, which is when expectations are most unstable.
In order to fully incorporate the potential efficiencies of the market into
policymaking, we need to consider a policy with no monetary instrument, or more
precisely, one where each market participant can conduct open market operations
using their own preferred policy indicator.
Because a policy regime without a unique instrument may seem somewhat
unfamiliar, we need to consider what the term “policy instrument” actually
means, and what it does not mean. In the recent literature it does not generally
mean “the variable directly impacted by monetary policy”, but rather something
closer to “operating target”7. Monetarists may favor a reserve instrument,
whereas Keynesians generally favor use of a short term interest rate, but both
would presumably agree that open market operations usually impact both the
base, and short term interest rates. A variable becomes a policy instrument when
policymakers directly target the variable, perhaps because they believe it provides
the best indicator of the stance of monetary policy. Monetarists see a falling
money supply as being indicative of tight money, Keynesians see rising (real)
short-term rates as indicative of tight money, and some “supply-siders” might
focus on falling commodity prices.
How could the central bank adopt a market-oriented monetary policy
without any policy instrument? One answer would be to allow private sector
open market operations. Of course under a government fiat money regime a
‘private sector open market purchase’ is just a fancy term for counterfeiting. For
the moment let’s assume that the central bank intends to retain its monopoly on
the revenue from money creation, i.e. seignorage. In addition, we also want to

6
For example, interest rate targeting has been relatively effective in recent decades—except when
an effective monetary policy has been most needed, i.e., in Japan during the past decade.
7
McCallum (2000, p. 72) points out that there is some ambiguity as to the distinction between an
indicator variable and a policy instrument. Here I am using the term ‘instrument’ in the sense in
which it is used in the Keynesian/monetarist policy debates, i.e., the monetary base and short term
rates are alternative policy instruments.

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reward traders who engaged in open market operations that, ex post, appear to
have helped move the economy closer to achieving the central bank’s policy
goals. Fortunately, both the seignorage and incentive issues can be addressed
with the same policy set-up, a system of private sector purchases and sales of CPI
futures, each of which trigger parallel central bank open market purchases and
sales8.
The Fed could announce that it is willing to buy or sell unlimited
quantities of CPI futures with a par value equal to the target price level. If there
was a 2% inflation target, then traders expecting above target inflation might
purchase $10,000 worth of CPI futures with a par value of (1.02)*(current CPI).
This purchase would trigger a parallel $10,000 open market sale by the Fed.
Similarly, a sale of $10,000 worth of CPI futures by the public would trigger an
equivalent open market purchase by the Fed. Only the central bank operations
would directly impact reserves and interest rates. But because the central bank
would respond automatically to private sector activity in the CPI futures market,
in a very real sense the private sector would be conducting monetary policy.
It might seem odd that traders would buy and sell CPI futures if they
thought that their actions would put monetary policy back on target, and thus
eliminate the profits that result from deviations between the actual CPI and its
target value. But recall that expectations are heterogeneous. Because traders’
expectations are based on a wide variety of different structural models, their
forecasts will be similarly diverse. As with any futures market, in equilibrium
there will be traders taking both long and short positions. Unlike ordinary futures
markets, however, equilibrium is not established by movements in the market
price (which is fixed by the Fed at its policy goal). Instead, equilibrium would be
established as trades of CPI futures contracts shifted monetary policy, and hence
moved the expected rate of inflation closer to the policy goal.
It is interesting to consider just how far this proposal moves us from the
current monetary policymaking set-up at the Fed. Bernanke and Woodford
(1997) argued that central banks could not simply target an external forecast, they
needed their own structural model. As we have already seen it is a mistake to
think in terms of “the” structural model, even FOMC policy decisions are almost
certainly (at least implicitly) based on 12 distinct structural models. Moving to a
market-based approach means that policy would be based on a still larger set of
structural models. In addition, this regime would move us from a ‘one-person-
one-vote’ open market committee structure, to a ‘one-dollar-one-vote’ decision-
making process. And it would also establish a more market-oriented reward
system.

8
The following is loosely based on earlier proposals by Sumner (1989) and Dowd (1994).

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One of the greatest advantages of this sort of market-oriented monetary

policy is that it does not require policymakers to agree on the optimal instrument
of monetary policy. Each member of the public can use their own preferred
policy indicator. The market’s implicit policy “instrument” might be a weighted
average of various asset prices. For example, under the policy regime discussed
above, a liquidity trap would lead investors to buy or sell CPI futures until the
money supply and/or the prices of foreign exchange, equities, and commodities
had risen to a level where the market expected an inflation rate of 2 percent9.
If the preceding list of changes seems rather modest, it may be because the
most important controversies in the field of monetary policy relate to the proper
goals of policy, not the best instrument for achieving those goals. Even under the
market-oriented approach discussed in this paper, we have assumed that the goal
of policy would be set by the monetary authority, perhaps the FOMC. Because
there is no generally accepted model showing the linkage between changes in
measurable economic aggregates such as prices and output, and the essentially
unmeasurable elements of a social welfare function (such the menu costs of price
changes and suboptimal employment fluctuations) there is no obvious way by
which the market could determine the appropriate goals of policy.10
Thus far I have skipped over a variety of practical problems associated
with the incorporation of the private sector into the monetary policymaking
process. In the next section I consider some of the objections that have been
raised to previous market-oriented monetary policy proposals. I then show that
these objections are either inaccurate, or are easily remedied.

5.a Previous Market-Oriented Monetary Policy Proposals

There is a long history of market involvement in monetary policy. During the

nineteenth century, for instance, currency was often issued by private commercial
banks. More recently, the “free banking” tradition was revived by Hayek (1976),
but his proposal for competing fiat currencies raised questions as to how the price
level would controlled. Soon after, a number of proposals11 were offered for
payments systems that lacked money in the traditional sense, and where the

9
Under a monopoly central bank there is a greater risk that policies of “quantitative easing” or
currency depreciation could lead a country to undershoot or overshoot in its attempt to exit from a
liquidity trap.
10
Sumner (1995) and Tinsley (1999) showed how the market could be used to make those goals
more credible by making it more costly for the central bank to adjust the target path of the goal
variable. In deciding whether to constrain its actions in this way the central bank would need to
consider the cost of unanticipated changes in the policy goal, as well as the benefits associated
with adjusting their policy goals as new theoretical insights become available about the social
welfare costs of various types of policy outcomes.
11
See Black (1970), Fama (1980), Hall (1982), and Greenfield and Yeager (1983).

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government’s role was limited to defining the unit of account in terms of a basket
of commodities.
Unfortunately, it is not easy to avoid using money for at least some
transactions, media of exchange with a fixed nominal value are exceedingly
convenient. But how can we be sure that the overall price level remains stable in
terms of those nominal assets? Greenfield and Yeager (1989) suggested that the
price level could be stabilized under a free banking system where various media
of exchange were indirectly convertible into a standard commodity bundle. That
is, “dollars” could be converted into a quantity of gold with fixed purchasing
power. But Schnadt and Whittaker (1993) argued that this type of system could
lead to a “paradox of indirect convertibility” which would make the system
susceptible to destabilizing arbitrage12.
Sumner (1994) argued that indirect convertibility could work, but only if
the standard bundle was composed of commodities with flexible prices, traded in
auction-style markets. He suggested that the paradox of indirect convertibility
was actually a variant of the “policy lag” problem that faces any monetary
regime; because of sticky prices there is a long lag between changes in monetary
policy, and changes in the overall price level. At about this time a number of
proposals were developed by Hall (1983), Sumner (1989, 1991), Hetzel (1990)
and Dowd (1994) which aimed at stabilizing the overall price level by using
monetary policy to peg the current price of a financial contract linked to the future
price level. Woolsey (1992) and Dowd (1993) recognized that because the price
of index futures contracts was flexible, i.e. their price would respond immediately
to changes in supply and demand, these futures contracts could be effectively
incorporated into the sort of indirect convertibility scheme envisioned by
Greenfield and Yeager (1989). In section 7 I will show how the Woolsey/Dowd
papers suggest a way that the reforms discussed in this paper could open the door
to further market reforms of the monetary system.
Hall (1983) developed one13 of the first modern proposals for a market-
oriented monetary policy that would target an economic aggregate. Hall
suggested that the central bank could pay interest on bank reserves and that the
interest rate should have two components. Reserves would earn a nominal
interest rate roughly comparable to the rate on risk-free short term assets, plus an
additional component indexed to changes in the price level. An increase in the
12
If there were an increase in the price of the standard bundle, then media of account would suffer
a temporary drop in purchasing power. This would encourage individuals to redeem currency
notes for enough gold to purchase the standard bundle. The quantity of currency in circulation
would decline and the price of the standard bundle would return to equilibrium. If, however, the
standard bundle also contained goods with “sticky” prices then there might be a delay in the
restoration of equilibrium, thus providing arbitrageurs with an unlimited profit opportunity.
13
As far as I know, the basic idea behind index futures targeting was first mentioned in an
unpublished paper by Thompson (1982).

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expected price level would sharply increase the demand for reserves, thus
increasing their real value (or purchasing power). Since reserves would serve as
the medium of account, an increase in the real value of reserves would tend to
reduce the overall price level. Conversely, a decrease in the expected price level
would reduce the expected return on reserves, reduce their value, and thus raise
the price level. Hall argued that these reserves would be close substitutes for
other risk-free short term securities. If so, then the demand for reserves would be
highly elastic with respect to the indexation portion of the interest rate, and the
policy regime would automatically tend to stabilize the (expected) price level.
Hall also noted that by suitably adjusting the indexation component of the interest
rate on reserves, the proposal could be amended to target any nominal economic
aggregate.
Although Hall’s proposal envisioned using market expectations to shift the
demand for money, most market-oriented schemes attempted to stabilize the price
level by having market expectations influence the supply of money. Hetzel
(1990) suggested that the central bank could use open market operations to target
the spread between nominal and indexed bond yields. Sumner (1989, 1995) and
Dowd (1994) suggested creating a consumer price index futures market, and then
using this futures market to implement monetary policy. At this point Bernanke
and Woodford (1997) published an important critique of all monetary policies that
“targeted the forecast”, specifically citing the proposals of Hetzel, Sumner, and
Dowd.
Consider a policy regime where the central bank tightened monetary
policy whenever CPI futures with a 12 month maturity rose more than 2% above
the current CPI, and vice versa. Bernanke and Woodford showed that if the
private sector anticipated these preemptive moves, and if the policy were
completely credible, then the price of CPI futures contracts would never rise
above its target value, and hence there would have been no market signal for the
central bank to have responded to in the first place. This dilemma, variously
termed the “circularity problem” or the “simultaneity problem,” would seem to
preclude the development of monetary regimes where central bank policy was
based solely on private sector forecasts. And Bernanke and Woodford’s critique
could apply to any forecast targeting regime, even if the forecast was developed
by a research unit within the central bank. The circularity problem applies to any
policy based on a forecast that is unconditional, that is, not linked to a specified
setting of the policy instrument.
It turns out that Bernanke and Woodford were only half right. The
circularity problem does apply to Sumner’s (1995) suggestion that the Fed peg the
price of a CPI futures contract, and Hetzel’s (1990) proposal that the Fed peg the
spread between the yield on conventional and indexed bonds (which is
presumably a proxy for inflation expectations.) If these policies were credible,

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then the policy indicator would always signal price stability, and thus would be
unable to send the Fed timely signals of a need to adjust policy. Their analysis
suggests that the central bank should not use open market operations to target the
price of a futures contract linked to the policy goal variable. But Bernanke and
Woodford’s critique does not apply to the policy regimes suggested in Sumner
(1989) or Dowd (1994), under which open market operations are determined by
the private sector.
Bernanke and Woodford argued that the central bank would benefit much
more from market forecasts of the goal variable if they were accompanied by
forecasts of the policy instrument. One example would be a CPI futures targeting
regime where proposed trades were contingent on various instrument settings, as
discussed in the previous section. Recall that under that type of regime the Fed
would only execute those trades that were contingent on an instrument setting that
equated the CPI futures price and the policy goal (2% inflation in this example.)
The auction would not be structured to elicit private sector forecasts of inflation—
the price of CPI futures would be pegged by the Fed—instead the market would
be signaling the instrument setting most likely to achieve the policy goal. This
type of policy regime would not be susceptible to the circularity problem.
Even better, consider policy proposals in which the Fed allows the private
sector to engage in open market operations in index futures contracts at a fixed
price (as in Sumner, 1989, and Dowd, 1994). Under those policy regimes the
private sector doesn’t signal a need for policy changes via fluctuations in a futures
price index; instead, if the market perceives the need for an adjustment in the
monetary base, it signals that perception by directly engaging in open market
operations, thus eliminating the circularity problem. Unlike with Sumner (1995)
and Hetzel (1990), the proposal for private sector open market operations actually
elicits an (implicit) market forecast of the quantity of money most likely to
achieve the policy goal, exactly the sort of private sector forecast that Bernanke
and Woodford suggested could be helpful to policymakers14.
In Hall’s (1983) proposal the central bank is essentially passive, and thus
it also avoids the circularity problem. Hall’s paper is a brilliant piece of work that
was unjustly ignored, perhaps because it was so far ahead of it’s time. But there
are a few reasons to doubt whether Hall’s plan is the best way to incorporate
market expectations into the monetary policy arena. Most of the monetary base is
composed of currency. In principle, interest could be paid on currency, but the
transactions costs involved probably make such a plan impractical. One could
envision paying interest on only the reserve portion of the base, but this would
greatly restrict the size of the “market” which would be used to implement
monetary policy. Many countries have only a few commercial banks, and others

14
See Jackson and Sumner (2006) for an alternative solution to the circularity problem.

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have many small commercial banks with little expertise in forecasting nominal
aggregates. In addition, during a liquidity trap the expected return on bank
reserves might become negative and (non-interest-bearing) cash would dominate
reserves. In that case it is difficult to see how both assets could serve as the
numeraire.
The Sumner and Dowd proposals are also susceptible to several potential
problems. Because they envisioned targeting monthly or quarterly economic
aggregates, these proposals would seem to be susceptible to an “end of period
problem,” which is actually two distinct problems. One problem, which I will
term ‘instrument instability’ occurs when important new information about the
likely future path of inflation arrives in the marketplace very late in a given
targeting period. For instance, suppose that between October 1 and October 31,
2006, the Fed was targeting October 2007 inflation. Also suppose that in late
October, 2006, the market received new information indicating that prices were
rising much faster than anticipated, and that next year’s inflation rate was likely to
exceed its target value. This would trigger massive inflation futures purchases, a
huge decrease in the monetary base and a huge increase in the fed funds rate. But
there is relatively little that one or two days’ worth of “tight money” can do to
offset mistakes that had been made over the previous month.
A second, and more serious, end of the period problem is the “first mover
disadvantage” discussed by Garrison and White (1997). The trading of inflation
futures will determine monetary policy, but monetary policy will also determine
future inflation. Thus it is in the interest of traders to know the stance of
monetary policy before they make their trades. In the previous example, the
trader that trades last on October 31st, 2006 will have the best information about
monetary policy during October 2006, and thus will have an advantage in
forecasting next year’s inflation. If all traders wait until the last minute, however,
then they will be forced to make inflation forecasts without knowledge of the
stance of monetary policy, i.e. the total amount of open market sales or purchases.
In addition, if traders waited until the last minute to engage in their trades, then
there wouldn’t be enough time for monetary policy to impact the price level.
Dowd (2000) noted that Garrison and White’s critique was not applicable
to his proposal because all trades for each contract would occur on a single day,
and because trades on a specific contract would occur well before the maturity
date. In addition, as with Bernanke/Woodford, the Garrison and White critique is
actually more relevant to Sumner’s (1995) proposal, in which the central bank had
to respond to changes in the price of futures contracts. In that case, if traders
waited until the last minute then they would have to trade without knowledge of
how the central bank had adjusted the money supply in response to their index
futures trading.

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Even with the superior schemes of Sumner (1989) and Dowd (1994),
however, there is some ambiguity as to exactly how the money supply would be
determined over the course of each targeting period. They envisioned futures
market transactions directly and fully determining the monetary base. The public
would be required to take a massive short position during each period in order for
the central bank to inject hundreds of billions of dollars of base money into the
economy. This would represent a huge loan by the central bank to the public,
which would be fully repaid at the announcement date for the goal variable. At
that moment, massive quantities of base money would flow back to the central
bank, only to be re-injected by a new CPI futures auction. These policy regimes
seem unnecessarily cumbersome and inefficient. In the next section we will look
at a policy proposal that addresses some of these inefficiencies.

5.b Is a Market-Oriented Monetary Policy Regime Actually Workable?

Because the idea of allowing the market to implement monetary policy is so

unfamiliar, it will be useful to consider some of the practical problems in the
context of a specific example. It is important to keep in mind that all of the
specific parameters used in this section will be arbitrary, and could easily be
modified by the central bank. For ease of exposition, I will consider a 3.65%
inflation target, with no allowance for base drift. With no loss of generality we
can assume that the (log of the) current level of the CPI is 1.0, and the one year
forward goal is for a CPI of 1.0365. (Note that the proposal could be easily
amended if policymakers preferred a nominal income growth target.)
As discussed earlier, we could implement this policy by having the Fed
create a CPI futures market, where each contract has a par value of 1.0365, and
then have the Fed offer to buy or sell unlimited quantities of CPI futures
contracts. If this system were adopted at the beginning of a new monetary regime
(say at the beginning of American history), then by now the Fed would be taking
a huge “long” position equal to the current size of the monetary base, i.e. roughly
$800 billion dollars. This would be necessary because, in order to prevent the
CPI from falling below its target level, the public would have to take a short
position in the CPI futures market large enough to spur the Fed into buying $800
billion dollars worth of CPI futures, and thus injecting $800 billion worth of base
money into the economy. To avoid assuming the risk associated with such an
extreme position, the Fed would probably want to start off each period with a
stock of base money equal to the forecasted equilibrium value. This might be
roughly equal to last period’s equilibrium stock of base money after the
completion of open market operations, plus an adjustment to reflect predictable
secular, seasonal, holiday, and day of the week variations in the demand for base
money.

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In addition to deciding how far out in the future to target CPI (what I will
term the ‘maturity’ of the goal variable), the Fed would have to decide the
duration of the goal variable. But we have already seen that a relatively long
targeting period creates an ‘end of period problem’. It may not be possible to
eliminate the end of period problem (except by returning to the contingent auction
format) but the problem can be greatly reduced by having the government
compute a new monthly CPI estimate each day, or 365 times each year. Because
the government now estimates the CPI only monthly, the other 353 estimates
would be generated by taking a weighted average of two consecutive monthly
estimates. Thus the estimate for November 25th would be for a 30 day period
surrounding that date. The period would extend 10 days into the next month, and
thus the estimate would be roughly 2/3 times the November CPI plus 1/3 times
the December CPI (both seasonally adjusted).
Because we are assuming a 3.65% growth target for the CPI with no base
drift, each day the Fed would be issuing new CPI futures contracts with a par
value that was 0.01%, or one basis point, higher than the target of the previous
day. Traders who waited more than 24 hours to get better information on the 12
month ahead CPI would find that the contract they had researched was no longer
being traded. Of course there would still be some incentive for traders to wait
until late in the trading day. Efficient markets theory suggests, however, that any
daily errors due to ignorance of the intentions of other traders would be serially
uncorrelated, and it is implausible that the random error in a single day’s
monetary policy would have a significant impact on long run macroeconomic
stability.
The efficiency of a market is almost certainly related to its depth. One
way of sparking interest in a CPI futures market is by having a low margin
requirement on purchases and sales of CPI futures contracts. On the other hand, if
the margin requirement were set too low, then the central bank would be exposed
to default risk. Assume that the Fed decided that a 10% margin on one year
forward CPI futures would be large enough to reduce default risk to a negligible
level. The Fed might also decide to pay interest on the margin accounts, perhaps
at a rate equal to the yield on one year T-bills. If the market remained too thin,
the Fed could increase the interest rate on margin accounts above the T-bill rate,
until there was sufficient trader interest to create an efficient market15.
To see how this might work in practice, consider an example using the
parameters discussed above. On November 25th, 2006, the Fed trades CPI futures
contracts with a par value of 1.0365, and a maturity of one year. Assume the 10%

15
A study of prediction markets by Wolfers and Zitzewitz (2004) found that turnover at the Iowa
Electronic Markets was only in the $10,000s per event, and in the $100,000s per event at
Tradesports.com. Yet even markets this thin were found to have had an impressive forecasting
record.

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margin accounts pay 6% interest per annum. Now consider an example where
one trader bought $10,000 worth of CPI futures and another trader sold an equal
amount. Assume that because of the overlapping period problem, and the data
lag, the level of the CPI on November 25th, 2007 is not calculated until two
months later, when it is found to be 2% above target. In that case, on January
25th, 2008, both positions will be settled. Each trader would then receive a
payment from the Fed with three components; the original margin requirement
($1000), 14 month’s worth of interest ($70), and a third component that represents
their “reward” for contributing to the monetary policymaking process. Because in
this case the actual CPI came in 2% above target, the trader who took a long
position will receive a $200 bonus, and a total payment of $1270, whereas the
trader taking a short position will receive a $200 penalty, and thus a total payment
of $870.
The effectiveness of this type of policy regime depends on both the
forecasting ability of the market, and the efficiency of the CPI futures market.
There are two reasons why this policy regime might fail to achieve its policy
goals. The market forecast of next year’s CPI may not be the optimal forecast, or
the price of CPI futures may not be equal to the market forecast. While it is
obviously difficult to know exactly how well the market would be able to forecast
the CPI under such a policy regime, in section 6 I will suggests several reasons
why the market is likely to do a better job than the FOMC.
There is also no easy answer to the market efficiency question. If there
are many people who wish to hedge against CPI risk, then there may16 be a risk
premium built into the price of CPI contracts. But when CPI futures markets have
been created, there has been relatively little trading, which suggests that there is
limited interest in that sort of inflation hedge, and therefore that the price of CPI
futures contracts is unlikely to be seriously biased by a risk premium. Ironically,
the very lack of interest in previous real world economic aggregate futures
markets is actually a point in favor of employing them for policy purposes. The
price of CPI futures contracts is more likely to reflect the future expected CPI if
traders are pure gamblers, not hedgers willing to accept a negative expected rate
of return in exchange for insurance against unanticipated price level fluctuations.
Of course this also suggests that in order to draw traders into such a market the
Fed would probably have to offer a rate of return on margin accounts that was
somewhat above the yield on one year T-bills.
Even if the price of CPI futures did include a risk premium, and thus the
price of the contracts was not equal to the market forecast, a market-oriented
monetary policy might still deliver relatively stable macroeconomic conditions.
In the long run, what matters isn’t so much the level of the CPI but rather its
16
Unless hedgers were equally distributed on both sides of the market, the price of CPI futures
contracts would diverge from the future expected value of the CPI.

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volatility. Unless the risk premium was time-varying, it would only have a one-
time impact on the level of the CPI, with no permanent impact on the more
important long run policy goal of 3.65% inflation.
The preceding example suggests that a workable market-oriented
monetary policy regime is certainly feasible. The purpose of this paper, however,
is not merely to suggest improvements in previous market-oriented policy
proposals, but also to show that economists have overlooked some of the
advantages of a market approach to monetary policy. One of the most important
advantages is discussed in the following section.

6. Why Should We Trust the Market more than the FOMC?

Previous proposals for a market-oriented monetary policy have focused on issues

such as the information lag. Sumner (1989) used an “island economy” set-up to
show that in a highly decentralized economy the market may have superior
information about the current state of aggregate demand. It seems likely,
however, that improvements in information technology will gradually erode any
market advantage in that area. Here I would like to argue that it is the problem of
model uncertainty that is paramount, and that the most significant gains from
moving to a market-oriented approach to policy come from the way that markets
aggregate forecasts where there is a diversity of opinion on the optimal model of
the economy.
Even if we had perfect information about the current state of the economy,
monetary policy’s long and variable impact lag makes it difficult to predict the
effect of a given instrument setting on future movements in prices and output.
Whether policy is being made by the FOMC, or by the market, policymakers must
forecast the impact of policy on future movements in the goal variable. But why
would market participants be better at forecasting than the members of the
FOMC? I would like to consider this question from several different
perspectives, beginning with a meta-analysis of money demand studies.
Stix and Knell (2004) showed that in 503 previous money demand studies
the mean estimate of the income elasticity of demand was 0.99 and the median
estimate was 1.00, which is essentially equal to the predicted value in many
conventional models of money demand. But because these studies varied in terms
of time period, location, and definition of the monetary aggregate, the standard
deviation of these income elasticity estimates was a surprisingly large 0.46.
Unfortunately, we do not know the true income elasticity of money demand (nor
if there is a “true” elasticity that is stable across time and region). Nevertheless,
assume for the moment that the true income elasticity is close to unity. In that
case it would be easy to envision a scenario where forecasts of this key parameter
by central bank economic research departments were, on average, superior to

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most private forecasts, and yet far inferior to the “market” estimate (here proxied
by the median value in the Stix and Knell study).
Of course the preceding example doesn’t prove that markets are
necessarily superior to centralized decision-making, but it suggests that if markets
are capable of efficiently aggregating private information, then even a relatively
high level of ‘noise’ in individual forecasts might well be associated with highly
accurate market forecasts. In a study of policy advice from multiple experts,
Battaglini (2004, p. 1) found that “the inefficiency in communication converges to
zero as the number of experts increases, even if the residual noise in experts’
signals is large [and] all the experts have significant and similar (but not
necessarily identical) biases”. And an experimental study by Lombardelli, Talbot,
and Proudman (2002) showed that groups made better decisions than individuals
when asked to control “a simple macroeconomic model that was subject to
randomly generated shocks in each period.”
Further support for the market-based approach to policy comes from the
increased popularity of artificially created markets, such as the Iowa Electronic
Markets and Tradesports.com. Smith (2003, p. 477) noted that the implicit
forecast of political election outcomes in the Iowa Electronic Markets tended to
show a smaller forecasting error than the average exit poll. Wolfers and Zitzewitz
(2004) discussed how more and more firms are constructing internal prediction
markets as a way of eliciting forecasts of useful variables such as sales revenue.
They argued (p. 121) that the “power of prediction markets derives from the fact
that they provide incentives for truthful revelation, they provide incentives for
research and information discovery, and the market provides an algorithm for
aggregating opinions.” Their research suggests that these markets are often quite
effective, despite a relatively low volume of trading.
Recent price volatility in tech stocks and real estate has created renewed
interest in market “bubbles”. There is now a fairly widespread perception that
markets often overshoot their fundamental values, and this has led to a great deal
of skepticism about whether markets aggregate information efficiently. Of course
we really don’t know much about what might cause a market bubble, or even how
to go about identifying this type of phenomenon. But let’s assume that bubbles
do exist. Would this weaken the argument for basing policy on prediction
markets? Here I will offer a contrarian view, that market bubbles may actually
provide one of the strongest arguments in favor of letting the market set monetary
policy.
Surowiecki (2004, pp. 23-65) argued that bubbles are caused by
“groupthink”, or “herding” behavior. The key to avoiding this phenomenon is to
insure that decisions are made by diverse groups featuring a wide range of
independent analysis. In fact, he argues that decentralized decision making will
often be superior even if the average intelligence of the group is lower than that of

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“expert” opinion. Surowiecki doesn’t deny that markets may also be susceptible
to groupthink--he even cites the overly-optimistic forecasts on internet traffic
growth that echoed around Wall Street during the late 1990s. But he seems even
more concerned by the groupthink arising out of small insular committees, citing
examples such as the (unanimous) committee decision to approve the Bay of Pigs
invasion of 1961.
When viewed from this perspective, one cannot help wondering whether
the Bank of Japan has too little diversity of opinion. And a study by Chappell,
McGregor, and Vermilyea (2005) found much circumstantial evidence that
FOMC members face subtle pressure to reach unanimous decisions. Consider
that even if there was complete uniformity of opinion about the optimal level of
inflation, one would expect a wide diversity of views regarding the optimal
instrument setting. Yet despite that fact that not all FOMC members agree on
even the appropriate goals of monetary policy, dissents are relatively infrequent.
We obviously don’t know whether Surowiecki’s groupthink hypothesis
explains some or all bubble-like phenomena, although it’s not clear we have a
better explanation. More importantly, however, we have become so conditioned
to looking for bubbles in markets, that we may have overlooked the fact that
essentially the same phenomenon is much more common in decision making by
small, homogeneous committees. If so, then large and diverse prediction markets
may actually reduce the chances that monetary policy decisions become distorted
by this sort of “market inefficiency”.

7. Concluding Remarks

Policymakers have a natural reluctance to engage in radical institutional change

without strong evidence that outcomes will be improved. Therefore it may be
useful to briefly consider the prospects for monetary policy becoming more
market-oriented in the near future.
Before implementing the sort of proposal discussed in this paper, central
banks will want to see some experimental evidence that market-oriented policy
regimes can improve the efficiency of monetary policy. This evidence could take
one of two forms. First, the Fed may decide to set up experimental games that
simulate the environment that would be faced by index futures traders. The
problem with this approach is that we don’t know the exact structure of the actual
economy--and as we saw in section 3, model uncertainty is actually one of the
most important motivations for market-oriented monetary reforms.
A more definitive test of the market approach could be safely undertaken
by first setting up the sort of subsidized CPI futures market discussed in section
5.b, but initially segregating it from the policy arena. Then the Fed could run a
“horse race”, comparing the forecasting ability of the market against the internal

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forecasts of the Fed’s economic research units. If the market produced superior
forecasts, then this would be a signal to allow the index futures trades to begin
determining monetary policy. In the unlikely event that the Fed’s internal
forecasts were consistently superior, the Fed could become a “profit center” for
the federal government by trading on their forecasts.
Once the market became involved in the implementation of monetary
policy, it would probably lead to further market reforms of the monetary system.
As noted earlier, some critics argued that the early “free banking” proposals had
failed to demonstrate that a regime of private currency issuers would necessarily
lead to price stability. Several decades ago Barro (1982, p. 110n) expressed the
following skepticism about free banking:

“Another possibility, which I have not given attention to in this paper,

involves removing the government from the money-issue business. Media of
exchange would then be provided entirely by private entities. The workings of a
private, noncommodity monetary system are not well understood (at least by
me).”

Glasner (1989), Woolsey (1992) and Dowd (1993, 1996) showed that
index futures offered a way of pinning down the (expected future) price level, and
thus removed the biggest roadblock to free banking. Once index futures targeting
became well established, there would be less resistance to allowing private banks
to issue currency—so long as that currency was also redeemable into a standard
index futures contract. Sudden abolition of the Fed is politically infeasible,
instead it is more likely to gradually “wither away” as more and more of its
functions are performed by market entities.
This is not the first paper to consider a market-oriented monetary policy
regime. Many of the previous proposals, however, failed to adequately address a
number of practical issues such as the ‘end of period problem’ and the ‘circularity
problem’. More importantly, these papers did not provide a convincing argument
for why monetary policy could be implemented most effectively with a
decentralized market-based approach. In this paper I have focused less on the
technical aspects of a market-oriented policy, and more on the conceptual
advantages of this approach. As a practical matter, it is the highly unconventional
nature of this sort of regime that is likely to be the biggest barrier to its adoption.
Thus it might be useful to conclude with a brief discussion of some factors that
point in the direction of further market reforms in the monetary arena.
Recent trends in world history provide a powerful argument for taking
seriously any proposal for a market-oriented public policy. Since 1980, the world
has seen a revolution in policymaking at two levels. In the arena of
microeconomic regulation, there has been a powerful world-wide trend toward

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privatization and deregulation. Paralleling the neoliberal trend in government

policymaking has been an equally dramatic change in macroeconomic theory and
policy. Since the 1980s, older Keynesian models have been replaced by “new
Keynesianism”, in which the focus of policy has shifted toward maintaining a low
and stable inflation rate, and perhaps also reducing the output gap. One of the
most important innovations in these newer Keynesian models is the increased
focus on market expectations. Expectations are assumed to be rational and the
impact of policy depends not just on the current setting of the policy instrument,
but also on the expected future time path of that variable. All of these changes in
theory and policy make monetary policymaking fertile ground for the sort of
innovations that harness the information from newly created policy markets.
As expectations have begun to play a more important role in economic
theory, we have also seen a dramatic increase in the sophistication of financial
markets. We already have futures markets for the fed funds rate, and the spread
between nominal and indexed bond yields provides a crude estimate of market
inflation expectations17. In the future we can expect to see the creation of more
and more explicit or implicit macro futures markets.
Looking further ahead, technological innovations will eventually lead to
even more basic policy innovations. For instance, the replacement of cash by
smart debit cards will allow for the payment of interest on cash balances. This
will reduce one of the drawbacks associated with Hall’s inflation targeting
proposal, the fact that only bank reserve holders would be able to conveniently
participate in the policy process. Improvements in information technology may
also allow for estimation of the price level in real time18. Such data would allow
for the creation of a “spot CPI” which would enhance the prospects for the sort of
indirect convertibility regime proposed by Greenfield and Yeager (1989.)19
While the precise path of reform is obviously highly uncertain, the general
direction of policy innovation seems almost inevitable given the twin trends of
increasing financial market sophistication and the increased emphasis on market
expectations in economic theory and policymaking. And even if the specific
reforms suggested in this paper never come to pass, consideration of optimal
monetary policy regimes can improve our understanding of the essential problems

17
Craig (2003) showed that the inflation forecast implicit in this interest rate spread may be
contaminated by a time-varying risk premium.
18
Note that this would not require real time estimates of all prices, but only the much smaller
subset of prices currently measured by government statisticians. Given the extensive real time
data already available to large retailers such as Walmart, such a possibility may arise sooner than
many imagine.
19
Even with the overall price level available in real time, a feasible indirect convertibility regime
would require that the price level include a non-trivial subset of completely flexible prices, such as
commodity prices.

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 Sumner: Let a Thousand Models Bloom: Making the FOMC an 'Open Market'

faced by policymakers, and may indirectly lead to other, more practical, policy
innovations.

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