Federal Funds Rate Target Research Articles

Monetary policy and fragility in corporate bond mutual funds

We document aggregate outflows from corporate bond mutual funds days before and after the announcement of increases in the Federal Funds Target rate (FFTar). To rationalize this phenomenon, we build a model in which funds’ net-asset-values (NAVs) are stale and investors strategically redeem to profit from the mispricing when they learn about the increases of FFTar. Consistent with the model’s predictions, we find that stale NAVs and loose monetary policy environments weaken (strengthen) outflows sensitivity to increases in FFTar during illiquid (liquid) market conditions. Our results highlight when and how monetary policy could systematically exacerbate the fragility of corporate bond funds.

Forecasting the direction of the Fed's monetary policy decisions using random forest

AbstractThe federal funds target rate is commonly considered to be an important indicator of the state of the US economy and is of keen interest to individual investors, financial firms, and other economic agents. In this paper, we focus on the discrete changes in the federal funds target rate during the period from January 1994 to June 2022 and apply the ordinal forest model, a random forest‐based prediction method for ordinal response variable. We examine the model's performance with 45 predictor variables which include macroeconomic and financial variables as well as forward‐looking survey measures. For an accurate and honest measure of the model performance, we employ single‐period‐ahead out‐of‐sample forecasting accuracy instead of evaluating the in‐sample fit. Our empirical results show the ordinal forest method significantly outperforms a benchmark that uses the most recent data among previous studies on federal funds target rate. We find that TB spread is the most informative from a forecasting perspective along with GDP, initial jobless claims, and survey measures.

Effect of Federal Funds Rate on CPI and PPI

One of the crucial jobs of central banks is to rein in inflation as it creates uncertainty in the economy and in private investment and ultimately negatively impacts the economy. If the source of inflation is positive demand shock, then raising the federal funds rate target is the right way to rein in inflation. If the source of inflation is negative supply shock, then raising the federal funds rate target will make things worse. In this study, the impact of FFR (federal funds rate) on CPI (consumer price index) and producer price index (PPI) is examined. Findings indicate that raising the federal funds rate will have a negative impact on both CPI and PPI with a 2-period lag. The possible explanation of this finding is that raising federal funds rate lowers aggregate demand, lowers the price level and thereby the CPI. And when CPI falls, it lowers per-unit profit, prompting producers to cut supply, which in turn lowers the demand for producer goods and services, and thereby lowers PPI.

Disclosure, Materiality Thresholds, and the Cost of Capital: Evidence from Federal Open Market Committee Announcements

We examine how managers’ disclosure decisions vary in response to monetary policy shocks. Specifically, we examine the extent to which firms issue Forms 8-K, press releases, and management forecasts following unexpected changes to the target federal funds rate. We find consistent evidence that unexpected decreases (increases) in the Federal Open Market Committee target rate lead to larger increases (decreases) in disclosure by firms that are more sensitive to monetary policy shocks. Furthermore, the disclosure response to target rate surprises is concentrated in Form 8-K items that require a materiality-based decision and hold when we examine a sample of M&A-participating firms. Extended tests show that our results are not attributable to changes in the cost of capital leading to increased disclosure because firms are simultaneously raising capital or hyping their stock. Overall, our results are consistent with arguments raised in recent research papers that changes in cost of capital influence firms’ materiality thresholds, which can affect their decision to disclose. This paper was accepted by Suraj Srinivasan, accounting. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2021.01896 .

Domestic or U.S. News: What Drives Canadian Financial Markets?

Using a GARCH model, we study the effects of Canadian and U.S. central bank communication and macroeconomic news on Canadian bond, stock, and foreign exchange market returns and volatility. First, central bank communication and macro news from both countries have an impact on Canadian financial markets. Second, Canadian central bank communication is more relevant than its U.S. counterpart, whereas in the case of macro news, that originating from the United States dominates. Third, we find evidence that the impact of Canadian news reaches its maximum when the Canadian target rate departs from the Federal Funds target rate (2002–2004) and thereafter. The introduction of fixed announcement dates (FAD) initially does not cause a noticeable break in the data. Finally, Canadian and U.S. target rate changes lead to higher price volatility, and so does other U.S. news. Other Canadian news, however, lowers price volatility.

Monetary Policy Rules vs Discretion: Social Cost and Benefits

Abstract In this article it is discussed the new monetary policy, the new instruments (monetary policy tools) that the Fed introduced after 2008 and 2020, the different monetary policy rules, and the social cost and benefits of this policy is measured. The first major Fed’s changes were on 12/20/2008 by altering the fed funds market in a number of different ways: (1) Zero fed funds rate. (2) The Fed started paying interest on reserves held by the bank or on behalf of depository institutions at Reserve Banks, subject to regulations of the Board of Governors, effective October 1, 2011 and interest on the overnight reverse repurchase agreement in 2014. (3) The close to zero deposit rates. (4) The Fed abolished the required reserves by making them since March 26, 2020 zero. The social cost is very high with these “innovated” policies. This zero federal funds target rate monetary policy is against depositors (bail in cost) and taxpayers (bail out cost); it is an unfair public policy and an anti-social monetary policy; and at the same time it is a risky one because it has created enormous bubbles in the stock market and a creeping high inflation. The different monetary policy rules reveal the unjustifiable low policy target rates. The latest monetary policy combined with the loss of self-sufficiency, the outsourcing, the unfair international trade, the recent peculiar coronavirus pandemic, and the current divisions inside the country are generating many challenges and risks for the future, which will cause the social cost to exceed the social benefits. JEL classification numbers: E52, E58, E4, E44, E23, D6. Keywords: Monetary Policy, Central Banks and Their Policies, Money and Interest Rates, Financial Markets and the Macro-economy, Production, Social Welfare.

Estimation of nested and zero-inflated ordered probit models

We introduce three new commands—nop, ziop2, and ziop3—for the estimation of a three-part nested ordered probit model, the two-part zero-inflated ordered probit models of Harris and Zhao (2007, Journal of Econometrics 141: 1073–1099) and Brooks, Harris, and Spencer (2012, Economics Letters 117: 683–686), and a three-part zero-inflated ordered probit model of Sirchenko (2020, Studies in Nonlinear Dynamics and Econometrics 24: 1) for ordinal outcomes, with both exogenous and endogenous switching. The three-part models allow the probabilities of positive, neutral (zero), and negative outcomes to be generated by distinct processes. The zero-inflated models address a preponderance of zeros and allow them to emerge in different latent regimes. We provide postestimation commands to compute probabilistic predictions and various measures of their accuracy, to assess the goodness of fit, and to perform model comparison using the Vuong test (Vuong, 1989, Econometrica 57: 307–333) with the corrections based on the Akaike and Schwarz information criteria. We investigate the finite-sample performance of the maximum likelihood estimators by Monte Carlo simulations, discuss the relations among the models, and illustrate the new commands with an empirical application to the U.S. federal funds rate target.

A model for policy interest rates

This paper introduces a model that addresses the key worldwide features of modern monetary policy making: the discreteness of policy interest rates both in magnitude and in timing, the preponderance of status quo decisions, monetary policy inertia and policy regime switching. We capture them by developing a new dynamic ordered-choice model with switching among three latent policy regimes (easing, neutral and tightening). The simulations and an application to the federal funds rate target demonstrate that ignoring these features leads to biased estimates, worse in- and out-of-sample predictions, and a qualitatively different inference. Using all Federal Open Market Committee’s (FOMC) decisions made both at scheduled and unscheduled meetings as sample observations, we model the Federal Reserve’s response to real-time data available right before each meeting. The new model, fitted for the Greenspan’s tenure, detects oscillating switches among latent regimes, identifies three types of status quo decisions, correctly predicts out of sample 90% of the next 111 FOMC decisions on the target rate, and clearly outperforms the linear models (including the Taylor rule), the conventional ordered probit and other discrete-choice models from the literature.

Monetary Policy and the Equity Term Structure

We study the impact of monetary policy on the term structure of equity prices. We find that short-term and long-term equity prices respond in opposite ways to changes in monetary policy. Following an unanticipated cut in the target federal funds rate, short-term equity prices fall while long-term equity prices rise on average. This pattern could arise if policy decisions signal information about economic conditions. We examine this mechanism and find that the price change of the short-term equity asset in the 30-minute window around an FOMC announcement significantly predicts both macroeconomic growth and professional forecast errors over subsequent quarters.

The Information Effect of Monetary Policy: Self-Defeating or Optimal?

As the Federal Reserve has become more transparent about its decisions on the federal funds target rate, the general public has begun to regard the rate as not only a benchmark interest rate, but also as a signal about the state of the economy. However, the specific information considered by the public to be revealed is not clearly understood. We investigate this question and find that the information revealed by monetary policy decisions is regarding future output growth, not inflation, and that such an information effect is theoretically optimal and does not make interest-rate policies self-defeating.

The making of hawks and doves

Personal experiences of inflation strongly influence the hawkish or dovish leanings of central bankers. For all members of the Federal Open Market Committee (FOMC) since 1951, we estimate an adaptive learning rule based on their lifetime inflation data. The resulting experience-based forecasts have significant predictive power for members’ FOMC voting decisions, the hawkishness of the tone of their speeches, as well as the heterogeneity in their semi-annual inflation projections. Averaging over all FOMC members present at a meeting, inflation experiences also help to explain the federal funds target rate, over and above conventional Taylor rule components.

Federal Reserve policy after the zero lower bound: an indirect inference approach

Regardless of whether the federal funds target rate has lifted off from the zero lower bound, the historical record of interest rates will be forever marred by the lack of variation in the aftermath of the great recession. This paper employs a method of indirect inference to analyze the interplay between unemployment rates, leading indicators and interest rates in an environment with near-zero interest rates. This method is used to estimate a decision tree for state-dependent Federal Reserve policy to estimate an alternative target rate series similar to those predicted by a shadow rate model.

Do Monetary Policy Announcements Shift Household Expectations?

We use a decade of daily survey data from Gallup to study how monetary policy influences households’ beliefs about economic conditions. We first document that public confidence in the state of the economy reacts instantaneously to certain types of macroeconomic news. Next, we show that surprises to the federal funds target rate are among the news that have statistically significant and instantaneous effects on economic confidence. Specifically, we find that a surprise increase in the target rate robustly leads to an immediate decline in household confidence, at odds with previous findings that suggest consumers are largely inattentive to economic developments. Monetary policy news about forward guidance and asset purchases does not have similarly clear and robust immediate effects on household beliefs. We document heterogeneity across demographics in the responsiveness of macroeconomic beliefs to aggregate news, and we relate our findings to existing evidence on informational rigidities.

Monetary Policy and Systemic Risk

We employ an event study approach to estimate the price reaction of U.S. financial stocks to 147 Federal Open Market Committee (FOMC) decisions about the Fed funds target rate for the period 2000-2015. We show that systemic risk tends to increase abnormal returns for announcements related to a positive unexpected change in the target rate (“Positive Surprise”). On the other hand, systemic risk tends to reduce abnormal returns for dates related to a “Negative Surprise” and a “Zero Surprise” (the announced rate is the same as the expected one). These results suggest that a higher than expected target rate can be advantageous to institutions with high levels of systemic risk. High short-term interest rates and a flat yield curve can increase the risk of a crisis, and therefore this finding could be explained by a “Too-Big-To-Fail (TBTF) hypothesis”: whenever the likelihood of a systemic crisis increases, investors buy stocks of financial firms that are more likely to be rescued.

Discussion of “Accounting quality and the transmission of monetary policy”

Armstrong, Glaeser and Kepler (2019) examine whether accounting quality affects the sensitivity of a firm's stock returns to monetary policy news. The authors document that firms with lower accounting quality experience more pronounced responses to surprise changes in the target Federal funds rate, consistent with proposed balance-sheet channel of policy transmission. We first discuss how this paper fits with prior literature on the role of accounting quality and firm investment and with recent work examining information frictions and policy transmission. We then question the intuition behind the paper's symmetric prediction. In addition, we highlight potential measurement issues related to returns and accounting quality. Lastly, we consider the key takeaways of the paper and provide suggestions for areas of future research.

Do Monetary Policy Announcements Shift Household Expectations?

We use a decade of daily survey data from Gallup to study how monetary policy influences households' beliefs about economic conditions. We first document that public confidence in the state of the economy reacts instantaneously to certain types of macroeconomic news. Next, we show that surprises to the Federal Funds target rate are among the news that have statistically significant and instantaneous effects on economic confidence. Specifically, we find that a surprise increase in the target rate robustly leads to an immediate decline in household confidence, at odds with previous findings that suggest consumers are largely inattentive to economic developments. Monetary policy news about forward guidance and asset purchases does not have similarly clear and robust immediate effects on household beliefs. We document heterogeneity across demographics in the responsiveness of macroeconomic beliefs to aggregate news, and we relate our findings to existing evidence on informational rigidities.

Rules versus Discretion: Inference Gleaned from Greenbook Forecasts and FOMC Decisions

AbstractFrom 1987 through 2013, the Federal Open Market Committee appears to have set its federal funds rate target with reference to Greenbook forecasts of the output gap and inflation and, at times, also to have made further adjustments to the funds rate as those forecasts were revised. If viewed in the context of the Taylor (1993) Rule, discretionary departures from the settings prescribed by Greenbook forecasts consistently presage business cycle turning points. Similarly, estimates from an interest rate rule with time‐varying parameters imply that, around such turning points, the FOMC responds less vigorously to information contained in Greenbook forecasts about the changing state of the economy. These results suggest possible gains from closer adherence to a rule with constant parameters.

Do Monetary Policy Announcements Shift Household Expectations?

We use a decade of daily survey data from Gallup to study how monetary policy influences households' beliefs about economic conditions. We first document that public confidence in the state of the economy reacts instantaneously to certain types of macroeconomic news. Next, we show that surprises to the Federal Funds target rate are among the news that have statistically significant and instantaneous effects on economic confidence. Specifically, we find that a surprise increase in the target rate robustly leads to an immediate decline in household confidence, at odds with previous findings that suggest consumers are largely inattentive to economic developments. Monetary policy news about forward guidance and asset purchases does not have similarly clear and robust immediate effects on household beliefs. We document heterogeneity across demographics in the responsiveness of macroeconomic beliefs to aggregate news, and we relate our findings to existing evidence on informational rigidities.

Monetary Policy Options at the Effective Lower Bound: Assessing the Federal Reserve's Current Policy Toolkit

We simulate the FRB/US model and a number of statistical models to quantify some of the risks stemming from the effective lower bound (ELB) on the federal funds rate and to assess the efficacy of adjustments to the federal funds rate target, balance sheet policies, and forward guidance to provide monetary policy accommodation in the event of a recession. Over the next decade, our simulations imply a roughly 20 to 50 percent probability that the federal funds rate will be constrained by the ELB at some point. We also find that forward guidance and balance sheet polices of the kinds used in response to the Global Financial Crisis are modestly effective in speeding up the labor market recovery and return of inflation to 2 percent following an economic slump. However, these policies have only small effects in limiting the initial rise in the unemployment rate during a recession because of transmission lags. As with any model-based analysis, we also discuss a number of c aveats regarding our results.

Did QE lead banks to relax their lending standards? Evidence from the Federal Reserve’s LSAPs

Using confidential loan officer survey data on lending standards and internal risk ratings on loans, we document an effect of large-scale asset purchase programs (LSAPs) on lending standards and risk-taking. We exploit cross-sectional variation in banks’ holdings of mortgage-backed securities to show that the first and third round of quantitative easing (QE1 and QE3) significantly lowered lending standards and increased loan risk characteristics. The magnitude of the effects is about the same in QE1 and QE3, and is comparable to the effect of a one percentage point decrease in the Fed funds target rate.