Federal Funds Rate Target Research Articles

Asymmetric Response of International Stock Markets to Fed Policy

This paper examines the asymmetric response of international stock markets to Federal Reserve policy. We find that a hypothetical unanticipated rise in the federal funds rate target has a negative effect on international stock returns in the bull market. This is consistent with the discount effect. In contrast, an unexpected rise in the federal funds rate target has a positive effect on international stock returns in the bear market. A higher interest rate may herald higher future cash flows in the bear market. This effect dominates the discount effect, so an interest rate rise leads to higher stock returns.

Does the Fed Control Interest Rates?

To what extent does TF, the target Federal funds rate set by the Fed, influence other rates? There is lots of variation in rates unrelated to TF, and any effects of TF on rates dissipate quickly for longer maturities. For short rates, all the tests have interpretations in terms of: (i) a Fed that has the power to control rates and uses it, and (ii) a Fed that has little power over rates or chooses not to exercise its power. In the end, there is no conclusive evidence (here or elsewhere) on the role of the Fed versus market forces in the long-term path of interest rates. (JEL E43, E58, G12)

Bayesian forecasting of federal funds target rate decisions

In this paper we examine which macroeconomic and financial variables have most predictive ability for the federal funds target rate decisions made by the Federal Open Market Committee (FOMC). We conduct the analysis for the 157 FOMC decisions during the period January 1990–June 2008, using dynamic ordered probit models with a Bayesian endogenous variable selection methodology and real-time data for a set of 33 candidate predictor variables. We find that indicators of economic activity and forward-looking term structure variables, as well as survey measures are most informative from a forecasting perspective. For the full sample period, in-sample probability forecasts achieve a hit rate of 90%. Based on out-of-sample forecasts for the period January 2001–June 2008, 82% of the FOMC decisions are predicted correctly.

Cojumps in stock prices: Empirical evidence

We examine contemporaneous jumps (cojumps) among individual stocks and a proxy for the market portfolio. We show, through a Monte Carlo study, that using intraday jump tests and a coexceedance criterion to detect cojumps has a power similar to the cojump test proposed by Bollerslev et al. (2008). However, we also show that we should not expect to detect all common jumps comprising a cojump when using such coexceedance based detection methods. Empirically, we provide evidence of an association between jumps in the market portfolio and cojumps in the underlying stocks. Consistent with our Monte Carlo evidence, moderate numbers of stocks are often detected to be involved in these (systematic) cojumps. Importantly, the results suggest that market-level news is able to generate simultaneous large jumps in individual stocks. We also find evidence of an association between systematic cojumps and Federal Funds Target Rate announcements.

Municipal Bonds and Monetary Policy: Evidence from the Fed Funds Futures Market

AbstractThis paper examines the impact of conventional and unconventional monetary policy on municipal bonds using a novel high‐frequency dataset. I use three proxies for monetary policy surprises: the surprise change to the current federal funds target rate, the surprise component in the Federal Open Market Committee (FOMC) balance‐of‐risk statement, and the unanticipated announcements of future large‐scale asset purchases. Estimation results show that monetary policy news have economically important and highly significant effects on municipal bond prices. Their daily responses are, however, substantially lower than the reaction of comparable Treasury notes. This work documents that market (in)efficiency, and the slow adjustment of municipal bond prices, can partially rationalize this discrepancy. © 2013 Wiley Periodicals, Inc. Jrl Fut Mark 34:434–450, 2014

The High-Frequency Response of Energy Prices to Monetary Policy: Understanding the Empirical Evidence

This paper examines the impact of conventional and unconventional monetary policy on energy prices, using an event study with intraday data. Three measures for monetary policy surprises are used: 1) the surprise change to the current federal funds target rate, 2) the surprise component to the future path of policy, and 3) the unanticipated announcements of future large-scale asset purchases (LSAPs). Estimation results show that monetary policy news has economically important and highly significant effects on the level and volatility of energy futures prices and their trading volumes. I find that, on average, a hypothetical unanticipated 100 basis point hike in the federal funds target rate is associated with roughly a 3 percent decrease in West Texas Intermediate oil prices. I also document that, in a narrow window around the Federal Open Market Committee meeting, the Federal Reserve’s LSAP1 and LSAP2 programs have a cumulative financial market impact on crude oil equivalent to an unanticipated cut in the federal funds target rate of 155 basis points. Monetary policy affects oil prices mostly by affecting the value of the U.S. dollar exchange rate. Intraday energy prices also respond to news announcements about the U.S. macroeconomy and inventories. The daily responses are never significant, except in the case of inventory news.

Forecast Combination for Discrete Choice Models: Predicting FOMC Monetary Policy Decisions

This paper provides a methodology for combining forecasts based on several discrete choice models. This is achieved primarily by combining one-step-ahead probability forecast associated with each model. The paper applies well-established scoring rules for qualitative response models in the context of forecast combination. Log scores, quadratic scores and Epstein scores are used to evaluate the forecast- ing accuracy of each model and to combine the probability forecasts. In addition to producing point forecasts, the effect of sampling variation is also assessed. This methodology is applied to forecast the US Federal Open Market Committee (FOMC) decisions in changing the federal funds target rate. Several of the economic funda- mentals influencing the FOMC decisions are integrated, or I(1), and are modelled in a similar fashion to Hu and Phillips (2004a, JoE). The empirical results show that combining forecasted probabilities using scores mostly outperforms both equal weight combination and forecasts based on multivariate models.

THE EFFECT OF MONETARY POLICY ON CREDIT SPREADS

AbstractWe analyze the effect of monetary policy on yield spreads between corporate bonds with different credit ratings over the business cycle. We use futures contracts to distinguish between expected and unexpected changes in the Fed funds target rate and several indicators to distinguish between different phases of the business cycle. In line with the predictions of imperfect capital market theories, we find that yields on corporate bonds with low credit ratings widen (narrow) with respect to those with high credit ratings following an unexpected increase (decrease) in the Fed funds target rate during recession periods. Several tests suggest that our results are robust to outliers, potential endogeneity problems, empirical specification, control variables, countercyclical risk premium in futures, and alternative definitions of credit spreads and economic conditions.

Did Federal Funds Target Rate Changes Affect the Market Value of Insurance Companies?

In this paper, we study the sensitivity of insurance companies’ stock returns with respect to expected and unexpected changes in the Federal funds target rate over the period 1988-2007. We confirm Bernanke and Kuttner (2005) that, as stocks in general, insurance stock returns are only sensitive to the unexpected changes in the Federal funds target rate, but not to the expected ones. However, market-adjusted stock returns do only show a reaction for the non-life insurers. For life insurers, there does not seem to be an industry specific effect on their market value. This can be explained by the business models life and non-life insurers adopt.

The Effect of Changes in the Federal Funds Rate Target on Market Interest Rates in the 1970s

The standard empirical test of whether Federal Reserve can influence interest rates is to regress interest rates on current and past (actual or unexpected) values of money growth. This literature generally finds little support for view that Fed can influence interest rates, except perhaps through positive impact on inflation expectations of increases in money growth. Based on an exhaustive survey of empirical studies on impact of money growth on short-term interest rates, Reichenstein concludes that the Fed appears to have little control over month-to-month changes in [short-term] interest rates.

Asymmetric response of hospitality stock prices to Fed policy actions

This paper examines asymmetric response of hospitality stock prices to Fed monetary policy actions in bull and bear markets. Empirical examinations comprise two critical steps. First, following Kuttner (2001), this study uses the federal funds target rate surprise as an appropriate identification of Fed monetary policy action. Second, by using a Markov-switching model of stock returns, this study explicitly identifies bull and bear markets. Empirical test results based on an event study framework reveal that the responses of airline, gambling, hotel and travel and leisure index returns to monetary policy surprises vary greatly in bear and bull markets. The response of airline, gambling and hotel index returns is substantially greater and more statistically significant in bear than in bull markets. Moreover, the significant impact of monetary policy surprises on airline, gambling and hotel index returns exists only in bear markets. While travel and leisure index return reacts strongly to federal funds target rate surprises in both bear and bull markets, the response of travel and leisure index return is significantly greater in bear markets.

Does the Fed Control Interest Rates?

To what extent does TF, the target Federal funds rate set by the Fed, influence other rates? There is lots of variation in rates unrelated to TF, and any effects of TF on rates dissipate quickly for longer maturities. For short rates, all the tests have interpretations in terms of: (i) a Fed that has the power to control rates and uses it, and (ii) a Fed that has little power over rates or chooses not to exercise its power. In the end, there is no conclusive evidence (here or elsewhere) on the role of the Fed versus market forces in the long-term path of interest rates.

The change in the CD rate–target federal funds rate linkage during the financial crisis

This study examines the target federal funds rate-Certificate of Deposit (CD) rate link over two time periods. The first period is 16 May 2000 to 31 July 2007 and the second is 1 August 2007 to 31 July 2009. August 2007 begins the initial stages of the financial crisis. A time-series analysis compares the two time periods. The results reveal a breakdown in the typical target–CD rate linkage in August 2007. For the 2-year period after August 2007 banks remained resilient to lower CD rates. This resiliency confirms the noted tightening of credit and bank uncertainty. During the 2-year period banks maintained firm CD rates as a way to attract funds in a period of growing uncertainty even with the target and other short-term rates falling.

Credit risk dynamics in response to changes in the federal funds target: The implication for firm short-term debt

The recent credit crisis has raised a number of interesting questions regarding the role of the Federal Reserve Bank and the effectiveness of its expected and unexpected interventions in financial markets, especially during the crisis, given its mandate. This paper reviews and evaluates the impact of expected and unexpected changes in the federal funds rate target on credit risk premia. The paper's main innovation is the use of an ACH-VAR (autoregressive conditional hazard VAR) model to generate the Fed's expected and unexpected monetary policy shocks which are then used to determine the effects of a Federal Reserve policy change on counterparty credit risk and more importantly short-term firm debt financing. The findings answer a longstanding question sought by researchers on the effect of policy makers' announcements on firm debt financing. The results clearly show that the Federal Reserve influences short-term debt financing through the credit channel for both expansionary and contractionary monetary policies. In particular, we find that the growth in counterparty risk appears less responsive to anticipated responses in the Fed funds rate that fail to materialize than to an unanticipated increase in the federal funds rate. Finally, we also document that the results appear to validate the Feds interventions in financial markets to stem counterparty risk and to make liquidity more readily available to firms.

The Monetary Policy Risks of Hospitality Stocks

On the basis of 100 monetary policy announcements made by the U.S. Federal Reserve between 1994 and 2005, we estimate the reaction of the hotel and restaurant industry stock values to the Fed’s monetary policy actions. We find that the portfolios of hotel industry stocks react strongly to unexpected changes in the Federal Funds Target Rate. Specifically, for a hypothetical surprise 25-basis-point rate cut, the value-weighted hotel industry stock portfolio registers a one-day gain of 245 basis points (or 2.45 percent). This response is 78 percent stronger than that of the overall equity market in the United States. On the other hand, the restaurant industry is not as responsive to the unexpected changes in the monetary policy. When the Federal Reserve announces a reversal of monetary policy in either direction, hotel industry stocks react more strongly than do others.

How 'Unconventional' are Large-Scale Asset Purchases? The Impact of Monetary Policy on Asset Prices

This paper examines the impact of large-scale asset purchases (LSAP) on U.S. asset prices (nominal and inflation-indexed bonds, stocks, and U.S. dollar spot exchange rates) using an event study with intraday data. The surprise component of LSAP announcements is identified from Financial Times articles. Estimation results show that the LSAP news has economically large and highly significant effects on asset prices, even after controlling for the surprise component of the Fed's conventional target rate decision and communication about its future path of policy. This study documents that the cumulative financial market impact of the Fed's LSAP program is equivalent to an unanticipated cut in the federal funds target rate that ranges between zero (for three-month yields) and 197 basis points (for ten-year yields), with the response of stock prices and foreign exchanges lying within this interval. These point estimates are, however, surrounded by considerable uncertainty. By looking at the cross-asset reactions, this work concludes that, for most U.S. asset prices, the effects of asset purchases are not statistically different from an unanticipated cut in the fed funds target rate. Finally, the response of U.K. asset prices (excepting FTSE 100 stocks) to the Bank of England's gilt purchases is quantitatively similar to the reaction of U.S. asset prices to the Fed's asset purchases.

The effects of Federal funds rate surprises on S&P 500 volatility and volatility risk premium

Abstract In this paper, we examine the effects of expected and surprise components in Federal funds target rate changes on realized and implied volatility. We find that surprise changes in the target rate significantly increase volatility. Consistent with the efficient market hypothesis, our analysis suggests that the expected component of a target rate change as well as the target rate change itself, do not significantly affect volatility. We also show that larger than expected decreases in the Federal funds target rate tend to lower the volatility risk premium.

Federal funds futures, risk premium and monetary policy actions

This article attempts to determine whether controlling for the time-varying risk premium would improve the ability of the federal funds futures to predict the Federal Open Market Committee's (FOMC) decision regarding the direction and magnitude of changes in the federal funds target rate at different forecast horizons. This is done using an appropriate categorical dependent variable model, which is estimated using real-time monthly data covering the period from January 1994 through September 2008. Following Piazzesi and Swanson (2008), control is made for the risk premium using a number of business-cycle indicators including nonfarm payrolls, the industrial production index, the help wanted index, and a measure of the Treasury yield spread. The results indicate that accounting for the risk premium modestly improves the predictive performance of the futures rate for the longer forecast horizons. Moreover, such a control appears to alleviate the over-prediction of changes in the target rate by the futures r...

Credit Spread Changes and Monetary Policy Surprises: The Evidence from the Fed Funds Futures Market

This study analyzes the impact of monetary policy actions on credit spreads of various rating categories and maturities, using federal funds futures to distinguish between anticipated and unanticipated changes in the federal funds rate. Two proxies for monetary policy shocks are the surprise change to the current federal funds target rate (target surprise) and the shock to the future path of policy (path surprise). Although credit spreads consistently respond to the target surprises, they rarely respond to the path surprises after controlling for the effect of the target surprises. The way that credit spreads respond to the target surprises changes across the maturities of corporate bonds. In addition, the empirical analysis indicates that the effect of the target surprises on credit spreads is more significant in economic recessions than in economic booms. © 2012 Wiley Periodicals, Inc. Jrl Fut Mark 33:103–128, 2013

U.S. Monetary Policy Surprises and Mortgage Rates

This article examines how the U.S. monetary policy surprises impact the mortgage rates in the nation and across five regions from 1990 to 2008. Regression analysis based on bootstrapping shows that surprises in the target federal funds rate (the target factor) have a significantly positive impact on the 1‐year adjustable‐rate mortgage (ARM) rate within the week of the Federal Open Market Committee announcements and the positive impact lasts up to 1 week after the announcements. Surprises in the future direction of the Federal Reserve monetary policy (the path factor) have significantly positive impacts on both the 1‐year ARM rate and the 30‐year fixed mortgage rates in the first week after the announcement. Furthermore, the responses of mortgage rates are asymmetric and affected by the size of monetary policy surprises, the stage of the business cycle and whether the monetary policy is tightening or loosening. There also exists heterogeneity in the mortgage rate pass‐through process across regions and monetary policy surprises have differential impacts on the regional mortgage rates. The cross‐region variations are mainly correlated with the regional housing market conditions, such as home vacancy and rental vacancy rates.