FRBSF Economic Letter
2007-15; June 15, 2007
On Forecasting Future Monetary Policy:
Has Forward-Looking
Language Mattered?
Today the Federal Open Market Committee is a good deal
more transparent about its policy actions and deliberations
than it was
only 15 years ago. As then-Governor Bernanke said in his
2004 speech, "Central Bank Talk and Monetary Policy":
This increase in transparency is highly welcome, for
many reasons. Perhaps most important, as public servants
whose
decisions affect the lives of every citizen, central
bankers have a responsibility to provide the public as
much explanation
of those decisions as possible, so long as doing so does
not compromise the decisionmaking process itself.
In that speech, he went on to say,
...to the extent that central bank talk provides useful
guidance to markets about the likely future path of
short-term interest rates, policymakers will exert greater
influence
over the longer-term interest rates that most matter
for spending decisions. At the same time, expanding
the information available to financial-market participants
improves the efficiency and accuracy of asset pricing.
Both of these factors enhance the effectiveness and
precision
of monetary policy.
"Central bank talk" takes many forms, including
Congressional testimony, speeches, articles, and interviews.
What seem particularly important for forecasters of future
monetary policy, that is, of the future federal funds rate,
are the FOMC statements, which are released at the conclusion
of each meeting and which enunciate the monetary policy
decision, and the subsequent releases of the minutes of
the FOMC meeting.
This Economic Letter reviews the changes in the content
of the FOMC statements over the past several years and
examines how the accuracy of market forecasts of monetary
policy has evolved. The analysis complements prior research
showing that, as the FOMC took steps to foster greater
transparency, the accuracy of the fed funds futures market
in predicting future fed funds rates has improved. In
recent years, the level of precision improved further as
forward-looking
language was included in the FOMC statements.
Federal funds futures market
The overnight federal funds rate is a key instrument
used by the Federal Reserve to conduct monetary policy.
In the
federal funds market, depository institutions lend their
excess reserves at the Fed to each other. The FOMC sets
the federal funds rate target and directs the New York
Fed to engage in open market operations to adjust the
supply of reserves so as to achieve the target. With this
direct
link between the federal funds rate and monetary policy,
the federal funds futures market provides a window to
the market's expectation about future monetary policy.
The
30-day fed funds futures contracts, which are traded
at the Chicago Board of Trade, allow investors to lock
in
today the federal funds rate in the future. Each $5 million
contract is cash settled against the average daily effective
overnight fed funds rate for the delivery month, as reported
by the New York Fed. While the contracts can go up to
the first 24 consecutive calendar months out, those most
actively
traded are between the current-month contract and the
ones about six months out, beyond which they become quite
illiquid.
Recently, the Chicago Board of Trade introduced binary
options on the target fed funds rate which directly let
investors take positions on all possible outcomes of
future regularly scheduled FOMC meetings; however, because
this
market is fairly new and currently has far less trading
activity than the fed funds futures market, it provides
insufficient data at this time to test its predictive
power.
Traders in the market buy or sell fed funds futures based
on their assessment of what the fed funds rate will be
in a particular month in the future. Thus, the market-clearing
prices of the futures represent the market consensus
of the expected future fed funds rate plus a risk premium.
This Letter focuses on the forecasting performance of
the
one-month and six-month fed funds futures. It uses the
observed implied rate and so abstracts from the risk
premium, which should be quite small for such short horizons.
On
each trading day during the study period, the one-month
(six-month) forecast errors are computed by comparing
the implied one-month (six-month)-ahead fed funds rate
from
the futures contracts to the realized monthly average
target rate one month (six months) hence. The futures are
settled
using the effective fed funds rates, and since these
rates are very close to the target funds rates in practice,
they
provide essentially the same results
Policy statements and predictability of policy: One month
ahead
In February 1994, the Federal Reserve began issuing press
releases announcing changes in the fed funds rate target
following the FOMC meetings, and, over time, their contents
have evolved. For example, since 1999, they have included
descriptions of the state of the economy and the rationale
for the policy action; since 2000, they have included
the "balance
of risks" to the outlook section; and since 2002 they
have included the votes of individual FOMC members and
preferred policy choices of any dissenters.
 Swanson (2006) examined the period from the late 1980s
to around 2003 and showed that the steps towards greater
transparency were accompanied by improvements in private
sector forecasts. Using daily data, I computed the absolute
forecast errors for one-month-ahead fed funds futures
contracts from 1989 to the present, which are plotted in
Figure 1,
and the results are consistent with those of Swanson.
The errors clearly exhibit a downward trend (abstracting
from
the three spikes in January, April, and September of
2001 when the FOMC reduced the funds rate target at three
unscheduled
meetings). The mean one-month absolute forecast error
was 15 basis points from 1989 through 1993, and it declined
to 7 basis points from 1994 to mid-2003, a 53% improvement
in forecast precision.
In mid-2003, an important development in FOMC communications
occurred. The statement following the June 24-25 meeting,
when the FOMC decided to lower the funds rate target
to 1%, included explicit language about future monetary
policy.
Expressing concern that "the probability, though minor,
of an unwelcome substantial fall in inflation exceeds that
of a pickup in inflation from its already low level," the
statement noted that this concern was "likely to predominate
for the foreseeable future." These words signaled
that because of the concern about the possibility of deflation,
the funds rate would likely stay at this historical low
for a while. The next FOMC statement, released on August
12, 2003, reaffirmed the point: "…policy accommodation
can be maintained for a considerable period" [italics
here and below added by author]. The "considerable
period" language was kept in the FOMC statements until
December 2003, when it changed to "patient in removing
its policy accommodation." Following the May 2004
meeting, despite no change in policy, the statement dropped
the "patient" language and replaced it with " … policy
accommodation can be removed at a pace that is likely
to be measured." This was widely interpreted as signaling
a tightening of 25 basis points at the next meeting, which
was in June, and, as expected, the FOMC did raise the funds
rate target by 25 basis points to 1.25%; and it continued
to raise the target by 25 basis points at each of the next
16 meetings to 5.25%. During this tightening phase, the "measured
pace" language was used in the FOMC statements from
June 2004 to November 2005, a total of 12 consecutive times.
As the FOMC approached the end of this tightening campaign,
the language in the FOMC statements started to change,
from "some further measured policy firming is
likely to be needed" (December 2005) to "some further
policy firming may yet be needed" (May 2006). After
the last tightening, in June 2006, the statement said that "any
additional firming that may be needed …will depend
on … incoming information." Note that after
the March 2007 meeting, despite no change in policy, the
small change in the FOMC statement from "any additional
firming" to "further policy adjustments" was
enough to be interpreted as perhaps signaling a shift to
a more neutral posture and resulted in strong, immediate
market reactions, although, as the statement clearly noted, "the
Committee's predominant policy concern remains the risk
that inflation will fail to moderate as expected." The
amount of attention market participants pay to FOMC communications
to infer future policy actions is noteworthy.
The inclusion of forward-looking language in FOMC communications
apparently helped market participants form their expectations
about future monetary policy more precisely, at least
in the near term (Yellen 2006). As Figure 1 shows, the
one-month
mean absolute forecast error declined to only 2 basis
points from June 2003 to the present, even though the target
funds
rate stayed at a historical low for more than one year
and then was raised by exactly 25 basis points 17 consecutive
times. This is a 71% improvement in forecast precision
over the 1994 to mid-2003 period. Overall, the evidence
suggests that, on average, the one-month federal funds
futures contract was quite accurate in predicting the
one-month-ahead target federal funds rate, and the already
fairly high
level of precision improved further when the FOMC used
forward-looking language in its statements. (Note that
the FOMC had briefly experimented with using forward-looking
language by announcing the policy "tilt" from
May 1999 to December 1999.
Evidence on predictability: Six months ahead
 As Figure 2 shows, the daily six-month absolute forecast
errors are much bigger than the one-month forecast errors,
which is not surprising, since the precision of the forecast
is expected to decline with the length of the forecast
horizon. However, as with the one-month forecast errors,
the six-month forecast errors also exhibit a downward
trend (again abstracting from the spikes in 2001 that were
associated
with policy changes at unscheduled FOMC meetings). Before
1994, the six-month mean absolute forecast error was
80 basis points. From 1994 to mid-2003, it declined to
48
basis points, a 40% improvement in forecast precision
over the pre-1994 period.
Since mid-2003, when the FOMC first included forward-looking
language, the six-month mean absolute forecast error
has declined further to 21 basis points, a 56% improvement
in forecast precision over the prior period. This evidence
suggests that the FOMC communication policy since mid-2003
not only improves the private sector's forecast of monetary
policy at the next FOMC meeting but also its forecast
of
policy about four meetings ahead. However, attributing
the improvement in forecast precision entirely to FOMC
communication may require some robustness checks that
are beyond the scope of this Letter. For example, if the
economy
is more stable and easier to forecast, then so is future
monetary policy. Thus, more research into these issues
is needed to sort out what contributes to the advances
in the predictability of future monetary policy.
Conclusions
This Letter examined the accuracy of the federal funds
futures contracts in predicting future federal funds
rates. Consistent with prior research findings, the fed
funds
futures forecast errors are found to decline over time
in general as the FOMC took steps towards greater transparency,
suggesting that the predictability of future monetary
policy has improved over time. In particular, since mid-2003,
the FOMC statements have included forward-looking language,
and the precision of the fed funds futures in forecasting
future fed funds rates has improved further. This evidence
suggests that the greater transparency did matter in
improving
the precision of the private sector's forecast of future
monetary policy. However, a more thorough understanding
of this relationship requires analyzing a significantly
longer time span that includes shifts in the stance of
policy. Simon Kwan
Vice President
References
[URLs accessed June 2007.]
Bernanke, Ben. 2004. "Central Bank Talk and Monetary
Policy." Speech delivered to the Japan Society Corporate
Luncheon, New York, NY (October 7).
Swanson, Eric. 2006. "Have Increases in Federal Reserve
Transparency Improved Private Sector Interest Rate Forecasts?" Journal
of Money, Credit, and Banking 38(3) (April) pp. 791-819.
Yellen, Janet. "Enhancing
Fed Credibility." FRBSF
Economic Letter 2006-05 (March 17).
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
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