I'm optimistic about US recovery. If I'm reading the signs right, the market is also optimistic about US recovery. But that's not what makes me optimistic. Again, if I'm reading the signs right, the market is more optimistic about US recovery than the Fed is. And the market believes it is more optimistic about US recovery than the Fed is. That's what makes me optimistic about US recovery.
Let's start with a bit of Wicksell. If the Fed sets a market interest rate above/below some natural rate, there will be a cumulative decline/rise in the price level. Throw in a bit of Keynes. And there will also be a decline/rise in real output too.
Now let's throw in some expectations. The actual natural rate matters. But what the market believes the natural rate is matters too, and probably matters even more than the actual natural rate. Start in equilibrium. Hold the actual natural rate constant. Hold what the Fed does constant. Now suppose the market changes its beliefs and (falsely) believes that the natural rate has increased. And suppose the market also believes that the Fed does not share the market's view, so will not change what it does. And suppose the market understands Wicksell, and Keynes. What happens?
Since the actual natural rate has not changed, and since the market rate set by the Fed has not changed, you might think that no individual will want to change his desired savings or investment. But, because each individual (falsely) thinks that the natural rate has increased, relative to the market rate, each individual thinks that every other individual will increase desired investment and reduce desired saving. So each individual expects the Wicksellian/Keynesian cumulative process will cause rising prices and output. And this is what causes each individual to increase his own desired investment and reduce his own desired saving. And so there is a Wicksellian/Keynesian cumulative process of rising prices and output.
Somewhere, deep in the metaphysical vaults of preferences and technology, there exists a true natural rate. And if everybody knew what it was, and the Fed did too, and set the market rate equal to it, the economy would be in metastable equilibrium, with no cumulative process in either direction. But the true natural rate matters much less than what the market believes the natural rate is. Because even if you are impatient, or have a good investment opportunity, you will not consume or invest as much if you expect falling prices and falling spending by everyone else.
And beliefs about the future matter too. If the market believes the Fed will set a market rate below the natural rate in future, then the market will expect a Wicksellian/Keynesian cumulative rise in prices and output in the future. And that causes a rise in desired investment and a fall in desired savings today. And so the cumulative process starts today, not in the future. And the Fed would have to raise the market rate right now, to prevent it.
It's the gap that matters. In the simplest Wicksellian story, the gap is the gap between the natural rate and the market rate. Throw in expectations about the future, and what matters is the gap between what the market believes will happen and what the market believes the Fed believes will happen. I think we have just such a gap right now. The market believes the Fed is too pessimistic. That creates an upside cumulative process. That's what makes me optimistic.