FRBSF Economic Letter
2004-28; October 8, 2004
Gauging the Market's Expectations about Monetary Policy
In recent months, some Federal Reserve officials have discussed
the organization's efforts at communicating to make the foundations
of their decisionmaking more transparent to the public. Janet Yellen,
president of the Federal Reserve Bank of San Francisco, said, "The
reason for the focus on communication is that economic developments
are affected by longer-term interest rates, equity values, the
exchange rate, and other asset values—and these factors depend
not only on the current [federal] funds rate, but, more importantly,
on the expected future path of the funds rate" (Yellen 2004).
Ben Bernanke, a member of the Board of Governors, spoke about the
potential for using market expectations as a way to gauge the efficacy
of Federal Reserve communication (2004).
Of course, one way to gather information on market expectations
is simply to ask market participants about their views of future
monetary policy, and, indeed, numerous surveys do just that. In
an efficient capital market, however, this information also should
be reflected in asset prices; that is, asset prices should reflect
the most up-to-date information, including monetary policy expectations,
that market participants actually are betting on. Thus, the expected
future path of monetary policy can be inferred from financial asset
prices. This Economic Letter describes an array of financial instruments
that are suitable for extracting expectations about monetary policy,
compares their forecasting power, and discusses some technical
considerations in using them to forecast monetary policy.
Which
financial market instruments and why?
Gurkaynak, Sack, and Swanson
2002 (GSS) examined several market-based measures of monetary policy
expectations and identified six money
market instruments that are potentially useful.
Term federal funds
rates. The federal funds rate—the policy instrument of the Federal
Reserve—is the unsecured overnight borrowing rate
among banks. Although overnight lending is by far the most active
segment of the federal funds market, banks can also borrow and
lend to one another for longer periods in this market. The rates
on these longer-term loans, or term federal funds rates, should
provide information about expected future levels of the overnight
federal funds rate, given banks' ability to substitute between
term federal funds and overnight federal funds.
Federal funds futures
rates. Federal funds futures contracts have been traded on the
Chicago Board of Trade (CBOT) since 1988. These
contracts have a payout at maturity based on the average effective
federal funds rate during the month of expiration. Thus, the value
of these securities reflects the expected month-average federal
funds rate. The CBOT offers contracts with monthly expirations
out to two years, but most of the trading activity is concentrated
in contracts with shorter horizons. Currently, federal funds futures
contracts are extremely liquid at expirations out to three months
and remain fairly liquid up to about six months. Also, the open
interest, that is, the total number of contracts outstanding, in
federal funds futures contracts has risen markedly since their
inception in 1988.
Term Eurodollar deposit rates. Term Eurodollars
are U.S. dollar-denominated time deposits held at financial institutions
outside the United
States. Eurodollar deposit maturities range from overnight to several
years, although volumes tend to concentrate on those with maturities
of less than one year. The credit quality of the financial institutions
offering Eurodollar deposits may not be the same as the financial
institutions that borrow in the federal funds market, so there
is likely a credit spread between the Eurodollar rate and the federal
funds rate.
Eurodollar futures rates. Eurodollar futures have been
traded on the Chicago Mercantile Exchange since 1982 and are the
most actively
traded futures instruments in the world. These contracts are settled
in cash based on the quoted three-month London Inter-Bank Offer
Rate (Libor) on the settlement date. Contracts expiring in March,
June, September, and December are available out to horizons of
ten years, although liquidity tends to decline at longer horizons.
Both trading volume and open interest are relatively high for contracts
expiring over the first several years. Since the value of these
contracts is directly tied to the Libor rather than to the federal
funds rate, the accuracy of these contracts for predicting U.S.
monetary policy will depend, as with term Eurodollars, on the extent
to which the Libor tracks the federal funds rate.
Treasury bill
rates. The U.S. Treasury bill market is well known for its extraordinary
liquidity and resiliency. With very active
secondary market trading of Treasury bills whose maturities range
from a few weeks up to a year, the bill rates provide information
about the future path of the overnight federal funds rate. However,
Treasury bills are viewed by market participants as default free,
whereas federal funds are a form of private short-term credit that
contains credit risk. This introduces a potential shortcoming of
Treasury bill rates as a predictor of future federal funds rates.
It should also be noted that some researchers have found that this
market could be segmented from the rest of the Treasury market,
which may lead to some idiosyncratic results.
Commercial paper rates. Commercial paper is unsecured short-term credit of maturity less
than 270 days issued by investment-grade
corporations. Most commercial paper issuance is concentrated at
maturities of less than 90 days, with an average maturity of around
30 days. Despite the large quantity of commercial paper outstanding
at a given time, most commercial paper is bought and held by institutional
investors with very little secondary market trading. Another complication
in using commercial paper rates to forecast federal funds rates
is the potential difference in credit risk between commercial paper
issuers and federal funds purchasers. Nevertheless, to the extent
that investors who buy and hold commercial paper would require
a return that is compatible with selling federal funds, the rate
at which commercial paper is issued contains information about
market expectations of future federal funds rates.
Predictive power
Using data from 1994 to 2001, GSS examined the
predictive power of these six market instruments in forecasting
the federal funds
rate. They reported that, over their sampling period, these instruments
explained between 50% and 80% of the changes in the federal funds
rate one to six months ahead. The reasonably good performance of
these instruments in forecasting future monetary policy over short
horizons seems to suggest that, over time, market participants
have been increasingly successful in anticipating monetary policy
actions. This may stem from the Federal Reserve's effort to improve
transparency over the years. In 1994, the Federal Open Market Committee
(FOMC) started explicitly announcing changes in the target federal
funds rate in a statement released on the day of the meeting; in
1999, the Committee began announcing its policy "tilt," indicating
the most likely future interest rate action; in 2000, it replaced
the "tilt" with a statement describing the "balance
of risks" to inflation and the economic outlook; in 2002,
it included in the statement the votes of individual Committee
members and the preferred policy choice of any dissenters.
GSS
found that the federal funds futures contracts dominate all other
instruments for predicting near-term changes in the federal
funds rate. The difference in the relative performance is most
striking over the first few months of the contracts, the period
in which the federal funds futures have the most liquidity. It
is not surprising that other instruments would do a fairly good
job at forecasting the federal funds rate changes as well, while
not being as accurate as the federal funds futures, since money
market instruments tend to be priced off each other. Indeed, GSS
found that the federal funds futures rates encompass or summarize
all of the information embedded in the rates of the other instruments
in predicting the future funds rate over the near-term horizon.
Over forecast horizons of one to four quarters ahead, the relative
predictive power of the different money market instruments is much
closer, and the forecasting power of all of them declines. Nonetheless,
over these longer horizons, the Eurodollar futures contracts appear
to have a slight edge over the other instruments in forecasting
the funds rate changes.
Expected federal funds rate path Based on the GSS findings, a reasonable
way to map out market expectations of the future federal funds
rate path would be to use the information
from the federal funds futures contracts for the near-term forecast
and the Eurodollar futures contracts for longer horizons. Before
translating the futures rates into the expected funds rate path,
we need to take into consideration the presence of the risk premium
in futures contracts. Since all futures contracts are simply bets
by investors today on the realization of the underlying contract
outcome in the future, which is uncertain at the time they place
the bet, investors who are risk-averse would demand a risk premium
for holding the futures contract. Hence, the observed futures rates
include both the expected realization of the contract rate and
a risk premium.
Assuming that the risk premium is constant, GSS
estimated that the risk premiums embedded in federal funds futures
rates are quite
small, beginning at just a few basis points for one-month contracts
and increasing only a few basis points per month thereafter. However,
more recent work by Piazzesi and Swanson (2004) shows that the
risk premium in federal funds futures contracts appears to be time-varying
and strongly countercyclical, suggesting that we need to exercise
caution in interpreting these market-based data, especially over
longer forecasting horizons.
In using the Eurodollar futures contract
to predict the future federal funds rate, the risk premium is further
complicated by
the differences in credit risk between Eurodollar borrowers and
federal funds borrowers, and between a longer-term Eurodollar loan
and the federal funds overnight loan. GSS estimated that the risk
premia embedded in Eurodollar futures contracts are about 10 to
20 basis points for one to two quarters ahead, respectively.
 Simply
assuming a stationary risk premium, Figure 1 shows market expectations
of the federal funds rate path as of May 4 and September
23 of this year. On May 4, for the first time this year, the FOMC
indicated that (then current monetary) "policy accommodation
can be removed at a pace that is likely to be measured." The
market promptly interpreted this as a signal that in forthcoming
FOMC meetings, the target federal funds rate would be raised from
the level at that time, which was 1%. On that date, the market
expected the funds rate to go up to 1.1% by July and to rise gradually
to 1.76% by the end of 2004 before reaching 3.3% by the end of
2005. Note that market expectations shift over time in response
to new economic data and financial developments. Now fast-forward
to September 23. After the Fed raised the target funds rate in
three steps to 1.75%, the market now expects the funds rate to
continue to rise to about 1.98% by the end of 2004. Interestingly,
the projected trajectory of the future funds rate path has been
revised down somewhat since May, perhaps in response to the soft
economic data released during the summer. As of September 23, the
market expected the federal funds rate to be at about 2.9% by the
end of 2005, which was almost one-half of a percentage point lower
than the expectation just a few months ago.
Conclusions
The research discussed here indicates that selected
financial market data contain fairly accurate predictions of
future monetary
policy
action. Specifically, the federal funds futures contract has
been found to have strong forecasting power for near-term
monetary policy,
and the Eurodollar futures contract does a reasonably good
job in forecasting the federal funds rate over longer forecasting
horizons. At the moment, prices from federal funds futures
contracts and
Eurodollar futures contracts indicate that market participants
are expecting the federal funds rate to rise to about 1.98%
by
December of this year and to about 2.9% by the end of 2005.
However, it should be noted that market expectations are constantly
shifting
and some subtlety is required to interpret the market-based
data. Further research would continue to improve our ability to
extract
useful information from financial market data.
Simon Kwan
Vice President, Financial Research References
[URLs accessed September 2004.]
Bernanke, B.S. 2004. "What
Policymakers Can Learn from Asset Prices." Remarks made before
the Investment Analysts Society of Chicago, Chicago, Illinois,
April 2004.
http://www.federalreserve.gov/boarddocs/speeches/2004/20040415/default.htm
Gurkaynak, R.S., B. Sack, and E. Swanson.
2002. "Market-Based
Measures of Monetary Policy Expectations." Working paper.
Board of Governors of the Federal Reserve System.
http://www.federalreserve.gov/pubs/feds/2002/200240/200240pap.pdf
Piazzesi,
M., and E. Swanson. 2004. "Futures Prices and Risk-Adjusted
Forecasts of Monetary Policy." NBER Working paper w10547 (June).
Yellen,
Janet. 2004. "Remarks on the U.S. Economy and Monetary
Policy." Presented to Seattle Community Leaders Luncheon,
September 9.
http://www.frbsf.org/news/speeches/2004/040909.pdf
|
