What happens if I know that you know what the Fed knows?

“For all the talk of the challenge facing officials as they orchestrate higher rates with so much money sloshing around, Thursday’s market operations weren’t much different in scale than previous days. And the benchmark rate rose 0.2 percentage point, or 20 basis points on Thursday — practically to the middle of the Fed’s intended range.” Bloomberg, Dec 19 2015.

To refresh your memories, “the talk” had been speculation that the Federal Reserve would be unable to control the short-term interest rate due to a multitude of factors – declining bank presence as market makers, the switch from bank deposits into money market funds, the absence of the Fed from the markets for nearly a decade blah blah blah. All rubbish. What is the gaping flaw in these arguments?

One of the major insights of the “Rational Expectations Revolution” is that, if everyone agrees on a price, then that price will prevail without any need for trading to get there. A “no trade equilibrium” is just that – prices adjust without disturbing portfolio allocations. So it was that the market had expected and accepted the Fed’s decision to raise rates, and prices adjusted without the need for any additional operational activity by the Fed.

The surprising aspect of “the talk of the challenge facing officials” is that it actually received serious publicity. To paraphrase Abbott and Costello: if I know that you know what the Fed knows, then you know that I know what everyone knows, and that’s about all anyone needs to know.