Friday, February 5, 2010

What should the Fed do?

If the economy is a signal processor, then the Fed's job is to compute the lower end of the yield curve such that the total curve is most like Normal, Zero mean. It computes the lower end of the curve with open market operations. The economy, because of finite precision, presents to the Fed a higher or lower basic sampling rate, at the low end. The Fed must assume a deflated or inflated economy, thus selecting the shortest sampling period, or highest sampling rate. It should deliberately sample at twice that rate, approximately.

Distribute a finite set of terms over an ex-post banker yield curve, allocating precision using Shannon. Then look at the optimum set, select the shortest of the terms, and shoot for that. The implicit assumption is that the bankers are doing maximum entropy spectral analysis along the axis in time.

What does that mean? At each term, the banker is trying to determine the "how often and how much", over a specific time period. Business plans compute that in predicted cash flow. The whole banking channel, wholesale, retail, and intermediates, in totality, should be considered an information channel. There should be some N independent terms along the banker yield, N the precision. The terms allocated so as to equalize the information flow for each bank loan. So, the steep portions of the curve will have more independent terms.

I would say to the Fed, target two year rates to be 1.5%, do this by trading in one year notes. Leave the long stuff alone. But I just eyeball the Treasury curve from my Universal Economic Calculator.

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