Understanding the Fed’s Reaction Function
Paper Session
Monday, Jan. 4, 2021 3:45 PM - 5:45 PM (EST)
- Chair: Yuriy Gorodnichenko, University of California-Berkeley
The Fed's Response to Economic News Explains the "Fed Information Effect"
Abstract
High-frequency changes in interest rates around FOMC announcements are a standard method of measuring monetary policy shocks. However, some recent studies have documented puzzling effects of these shocks on private-sector forecasts of GDP, unemployment, or inflation that are opposite in sign to what standard macroeconomic models would predict. This evidence has been viewed as supportive of a "Fed information effect" channel of monetary policy, whereby an FOMC tightening (easing) communicates that the economy is stronger (weaker) than the public had expected. We show that these empirical results are also consistent with a "Fed response to news" channel, in which incoming, publicly available economic news causes both the Fed to change monetary policy and the private sector to revise its forecasts. We provide substantial new evidence that distinguishes between these two channels and strongly favors the latter; for example, (i) high-frequency stock market responses to Fed announcements, (ii) a new survey that we conduct of individual Blue Chip forecasters, and (iii) regressions that include the previously omitted public macroeconomic data releases all indicate that the Fed and Blue Chip forecasters are simply responding to the same public news, and that there is little if any role for a "Fed information effect".Monetary Policy Surprises and Exchange Rate Behavior
Abstract
Central banks unexpectedly tightening policy rates often observe the exchange value of their currency depreciate, rather than appreciate as predicted by standard models. We document this for Fed and ECB policy days using event studies and ask whether an information effect, where the public attributes the policy surprise to an unobserved state of the economy that the central bank is signaling by its policy may explain the abnormality. It turns out that many informational assumptions make a standard two-country New Keynesian model match this behavior. To identify the particular mechanism we condition on multiple asset prices in the event study and model implications for these. We find that there is heterogeneity in this dimension in the event study and no model with a single regime can match the evidence. Further, even after conditioning on the information effects on longer term interest rates, there may be independent information in the reaction of exchange rates. Our results show that existing models have a long way to go in reconciling event study analysis with model-based mechanisms of asset pricing.Monetary Policy Expectation Errors
Abstract
We use survey data on expectations about future monetary policy to decompose excess returns to fed funds (FF) futures and overnight index swaps (OIS) into a term premium and an expectation error component. We find that excess returns are almost entirely driven by expectation errors, while term premia are slightly negative and economically small. We show that most of the expectation errors stem from market participants underestimating how aggressively the Federal Reserve has eased policy during the last three decades. Our evidence suggests that market participants at the time were unaware of changes in the central bank's reaction function, in particular the importance attributed to deteriorating financial conditions and falling stock market returns. We confirm our main results in an international sample of six major currencies.Monetary Policy Transparency and the Information Effect
Abstract
In this paper, we investigate the impact of monetary policy transparency measures on the relevance of the information effect channel of central bank communication. Our paper focuses on the switch in the Bank of England's communication strategy, occured in August 2015, from a multi-day to a single-day release schedule. Before August 2015, the minutes of the monetary policy committee and the inflation report (i.e. the Bank's analysis of the economic outlook), were published only some weeks after the monetary policy decision. By contrast, after August 2015, the Bank of England started releasing all accompanying documents alongside the policy rate announcement, in the attempt to increase the transparency of its policy-making process. We construct an interest rate surprise series for the release of each one of the three communication documents of the Bank, and provide evidence that information effects are a key driver of the financial market response to central bank communication for each one of these documents. Before August 2015, according to our results, the information effect accounted for approximately two thirds of the interest rate surprise, the inflation expectations, and the equity price variation on the release days. However, we find that the switch from a multi-day release schedule to a single-day communication strategy markedly reduced the importance of information effects. Our findings suggest that the degree of transparency of a central bank's policies significantly affects the quantitative relevance of the information effect and the associated asset price response.JEL Classifications
- E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit