New Expectations in Monetary Policy

The ridiculous entries in Lolfed.com and reactions it receives (from Paul Krugman no less) demonstrate the decline in confidence that Americans have come to regard both the US Fed Chairman Ben Bernanke and Treasury Sec. Hank Paulson with. So much so that the unexpected announcement by the Obama transition team of the appointment of a new treasury chief in the person of current NY Reserve President Timothy Geithner was all that was needed to generate a much needed lift late Friday after a near disastrous week on Wall Street.

Here in Australia, the monetary and fiscal authorities have been keen to do a similar two step as the Americans with the same limited effect. Back in May of this year, the RBA was put under scrutiny over its decision to raise interest rates. Having shown its audacity in doing so during the election season that toppled the Howard government, it was given the imprimatur by Treasurer Wayne Swan who in declaring a war against inflation since taking office set the tone for monetary and fiscal policy to be on coordinated footing.

It didn't matter that Joseph Stiglitz, a Nobel Prize winning economist had been appearing on local TV regarding the Australian situation on inflation and the policy on inflation targeting which he predicted would be abandoned within five years because of its inefficacy to deal with the importation of inflation through petrol and food prices.

The defense that it was the commodities driven terms of trade boom generating price inflation notwithstanding, the oracle of Stiglitz has been proven true in less than six months with the higher than anticipated RBA cut of 100 basis points and further cuts in the offing, despite inflation exceeding the upper band of the 2 to 3 percent range. Why is it then that macroeconomic policy makers often fail to get their settings right?

Could it be that they are still operating under a misguided view of the world that sees agents as purely rational? To what extent do adaptive rather than rational expectations play a role in resolving the problem?