Market Anticipations of Monetary Policy Actions

Abstract

The purpose of this paper is to investigate the extent to which market participants anticipate Federal Reserve policy actions. The topic is central to macroeconomics. Since the early 1970s theorists have emphasized that a complete model of the economy requires a full specification of the behavior of policymakers. Otherwise, there is no way to model the expectations upon which private agents base their decisions. The recent trend in monetary policy has been toward greater transparency, accountability, and credibility. This trend is largely explained by two ideas. First, the economics profession has accepted the proposition that monetary policy is the fundamental determinant of inflation in the long run.1 Second, central bank credibility and clear market expectations about monetary policy are critical to policy success.2 The key theoretical development in this context was the application of rational expectations to macroeconomics and the statement of the famous Lucas critique. Lucas (1976) argued that the economy and policymakers are interdependent. Specifically, the public forms expectations of the dynamic feedback rule that policymakers follow to implement policy. This line of argument led naturally and immediately to the distinction between expected and surprise policy actions and a number of papers exploring their different effects on the economy.3 For example, the more transparent the central bank, the less likely that it will be able to institute a surprise inflation to temporarily raise output growth. Our purpose is not to add to the extensive theoretical literature, but instead to document in considerable detail the extent to which U.S. monetary policy has become increasingly open and transparent. The trend toward greater transparency has been especially evident in recent years.4 In 1994, the FOMC began the practice of announcing policy actions immediately upon making them, and in 1995 the practice was formally adopted.5 Since August 1997 the FOMC has included a numeric value of the “intended federal funds rate” in each directive. Since May 1999 a press statement has been released at the conclusion of every meeting. These press statements initially included a numeric value for the “intended federal funds rate” and a statement of the “policy bias.” In February 2000 the FOMC replaced the “policy bias” in the Directive that had been used since February 1983 with a statement of the “balance of risks.”6 In this statement the FOMC indicates its beliefs about how the risks of heightened inflation pressure and economic weakness are balanced over the foreseeable future. The new language was not intended to indicate the likely direction or timing of future policy moves. These moves toward greater openness and transparency should have increased the ability of markets to anticipate policy actions. Poole and Rasche (2000) and Kuttner (2001) used data from the federal funds futures market to estimate the extent to which the market has anticipated the Fed’s actions. While their methodologies differ slightly,