To Fed Watch or Not to Fed Watch: Equilibrium Analysis of Bank System Dynamics

Abstract

We build a model economy in which Fed watching occurs. There is a huge number of blogs, financial letters, and news reporting that talks about what the Federal Reserve is likely to do. We model this behavior by allowing for banks to Fed watch, meaning that the bank will apply a costly forecasting technology to predict next period’s price level. Here, the banks accept deposits to insure against idiosyncratic liquidity shocks. Within this model economy, we characterize the price-level dynamics. Our findings have direct implications for the notion of banking crises though related precisely to the role of insurance, not output fluctuations. We derive conditions in which there are endogenous oscillations between price level spikes and price-level falls; in other words, the model economy generates boom-and-busts cycles as real balances fluctuate from high to low values. We extend the model economy to consider how heterogeneity exists with the set of central bankers as they could have heterogeneous forecasts of the next-period price level.