The Effects of Policy Guidance on Perceptions of the Fed’s Reaction Function | Federal Open Market Committee | Federal Funds Rate

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The Effects of Policy Guidance on Perceptions of the Fed’s Reaction Function
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    This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in this paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors. Federal Reserve Bank of New York Staff Reports The Effects of Policy Guidance on Perceptions of the Fed’s Reaction Function   Katherine Femia Steven Friedman Brian Sack Staff Report No. 652  November 2013  The Effects of Policy Guidance on Perceptions of the Fed’s Reaction Function Katherine Femia*, Steven Friedman † , and Brian Sack  ‡    Federal Reserve Bank of New York Staff Reports , no. 652  November 2013 JEL classification: E52, E58 Abstract In the past few years, the Federal Open Market Committee (FOMC) has been using forward guidance about the federal funds rate in a more explicit way than ever before. This paper explores the market reaction to the forward guidance, with particular focus on the use of calendar dates and economic thresholds in the FOMC statement. The results show that market participants interpreted the FOMC’s policy guidance as conveying important information about the Committee’s policy reaction function.  In particular, market participants came to expect the FOMC to wait for lower levels of unemployment for a given level of inflation before beginning to raise the target federal funds rate, thereby shifting to a more accommodative policy approach aimed at supporting the economic recovery. Key words: monetary policy, forward guidance  _________________ *Femia: Corresponding author, Federal Reserve Bank of New York (e-mail: katherine.femia@ny.frb.org). The views expressed in this paper are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. † Friedman: Fischer, Francis, Trees & Watts. Opinions and analyses expressed are the personal views of the authors and do not represent the views of Fischer, Francis, Trees & Watts, Inc. or its affiliates, which provide no assurance as to the completeness or accuracy of the information contained herein. ‡ Sack: D. E. Shaw Group. Any views expressed here, and any errors, are the authors’ own and do not represent in any way those of the D. E. Shaw Group. Steven Friedman and Brian Sack were officers in the Federal Reserve Bank of New York’s Markets Group at the time this paper was written. To view the authors’ disclosure statements, visit http://www.newyorkfed.org/research/author_disclosure/ad_sr652.html.  1 Introduction Communications about the future path of the federal funds rate can be a powerful monetary policy tool, as expectations about the future course of monetary policy have a strong influence on broader financial conditions and hence on economic outcomes. Such a tool may be particularly important at times when the use of the central bank’s main policy inst rument is constrained. Indeed, with the target federal funds rate having reached the zero bound in recent years, Chairman Bernanke has repeatedly pointed to this type of communication as one of two key tools still available to the Federal Open Market Committee (FOMC), along with changes to the size and composition of the Federal Reserve’s balance sheet. 1  In the past few years, the FOMC has been using forward guidance about the federal funds rate in a more explicit way than ever before. Initially, it provided qualitative information about the types of economic conditions that would warrant keeping the federal funds rate at its near-zero level. Subsequently, it provided an explicit calendar date through which it expected this policy setting to be maintained and, more recently, explicit economic thresholds that it believed would warrant maintaining the policy setting. This more explicit guidance about the federal funds rate has been part of the FOMC’s effort to lower longer-term interest rates and ease financial conditions more broadly. This paper explores the market reaction to the forward guidance that the FOMC has provided about the federal funds rate, with particular focus on the use of calendar dates and economic thresholds in the FOMC statement. We investigate whether shifts in the calendar-date guidance conveyed information about the FOMC’s reaction function  (that is, the way in which the Committee adjusts policy in response to a given change in macroeconomic conditions) or simply information about prospects for the economy itself. We also assess how the perceived reaction function that was reached under calendar guidance compared to the more explicit guidance that the FOMC provided through the use of economic thresholds. Innovations in FOMC Communication A considerable body of research has emphasized the importance of expectations about future interest rates in influencing macroeconomic outcomes. 2  This literature has shown that Federal Reserve communications, including FOMC statements containing forward guidance, have typically had significant effects on those interest rate expectations. 3  Gurkaynak et al (2005a), for example, estimate that information about the future path of the federal funds rate can have a much larger effect on longer-term Treasury yields than actual changes in the federal funds rate. This body of research provided an empirical backdrop for the FOMC ’s communication policy in recent years, and the market response to 1  For example, see Bernanke (2012). 2  See Eggertsson and Woodford (2003) and Eggertsson and Woodford (2006). 3  Bernanke, Reinhart, and Sack (2004); Gürkaynak, Sack and Swanson (2005a and 2005b); Campbell et al (2012).  2 these recent communications seems to further support the earlier conclusion that these sorts of policies can lower interest rates and ease conditions in financial markets. Since 2008, the FOMC has taken several notable steps regarding its policy guidance. As summarized in Table 1, the FOMC began providing guidance about the length of time that the federal funds rate would remain near the zero bound in December 2008. Initially, this guidance was qualitative in nature, with the FOMC stating its expectation t hat “exceptionally low levels of the federal funds rate” would be appropriate first for “some time” and then , in subsequent statements, for “an extended period.” At the November 2009 meeting, the Committee included additional information about the macroeconomic indicators on which it based this judgment, essentially providing qualitative information about its policy reaction function. A further significant innovation occurred in August 2011, when the FOMC included a calendar date associated with the length of time that it expected economic conditions to warrant a near-zero federal funds rate , saying that such conditions were likely to persist “at least through mid - 2013.” 4  The decision to communicate about the likely path of the federal funds rate more than two years ahead was seen by some as a very aggressive step, although the Committee was careful to state that this calendar date did not represent an unconditional commitment to follow that path. The calendar-based guidance was subsequently changed on two occasions, extending it to “at least through late 2014” at the January 2012 meeting and “at least through mid - 2015” at the September 2012 meeting. Lastly, the FOMC made another important innovation in December 2012, when it adopted explicit economic conditions that it thought would warrant the current target range for the federal funds rate. Specifically, the FOMC said that it anticipates that this range will be appropriate “ at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer -run goal, and longer-term inflation expectations continue to be well anchored .”  This language indicates that these economic conditions are thresholds rather than triggers, meaning that a violation of one of the conditions would have to be breached before a rate hike occurred, but that such circumstances would not require an immediate rate hike. 5   4  The FOMC statement indicated that the target federal funds rate would rem ain “exceptionally low.” In this piece, we interpret “exceptionally low” as meaning the current range of 0 to 25 basis points.   5   In a February 2013 speech, Vice Chair Yellen commented that, “It deserves emphasis that a 6 -1/2 percent unemployment rate and inflation one to two years ahead that is ½ percentage point above the Committee’s 2 percent objective are thresholds for  possible  action, not triggers that will necessarily prompt an immediate increase in the FOMC’s target rate”.  
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