«Abstract The 1990s and early 2000s witnessed an unprecedented increase in central bank transparency around the world, yet there has been little ...»
Federal Reserve Transparency and Financial Market
Forecasts of Short-Term Interest Rates
Eric T. Swanson
Board of Governors of the Federal Reserve System
The 1990s and early 2000s witnessed an unprecedented increase in central
bank transparency around the world, yet there has been little empirical work
that convincingly demonstrates any economic beneﬁts of increased central
bank transparency. This paper shows that, since the late 1980s, U.S. ﬁnancial
markets and private sector forecasters have become: 1) better able to forecast the federal funds rate at horizons out to several months, 2) less surprised by Federal Reserve announcements, 3) more certain of their interest rate forecasts ex ante, as measured by interest rate options, and 4) less diverse in the cross-sectional variety of their interest rate forecasts. We also show that increases in Federal Reserve transparency are likely to have played a role: for example, private sector forecasts of GDP and inﬂation have not experienced similar improvements over the same period, indicating that the improvement in interest rate forecasts has been special.
JEL Classiﬁcation: E52, E58, E43, E44 Version 1.2 February 9, 2004 I thank Jim Clouse, Vincent Reinhart, Bill Whitesell, and John Driscoll for helpful discussions, comments, and suggestions, and Ryan Michaels for excellent research assistance. The views expressed in this paper, and all errors and omissions, should be regarded as those solely of the author, and do not necessarily represent those of the individuals or groups listed above, the Federal Reserve System, or its Board of Governors.
1. Introduction The 1990s and early 2000s witnessed an unprecedented increase in central bank transparency, with New Zealand, Canada, the U.K., Sweden, Finland, Israel, Australia, Spain, the European Central Bank, Norway, and several developing countries all adopting an inﬂation targeting framework for monetary policy,1 and many other central banks dramatically increasing the amount of information regularly released to the public. In the U.S., the Federal Reserve began explicitly announcing changes in its federal funds rate target in 1994, began indicating the likely future course of interest rates or “balance of risks” to its economic outlook in 1999, and began releasing individual votes of Committee members in 2002, to name just a few examples (see Table 1 for additional examples).
Yet despite the apparent international consensus that increased central bank transparency conveys economic beneﬁts, there is very little empirical work convincingly demonstrating the existence of any such beneﬁts.
One reason for the shortage of conclusive results may be the ambitiousness of previous emprical studies. Demertzis and Hughes Hallett (2002) look for a relationship between central bank transparency and the level or the variability of inﬂation and output across countries. But cross-country diﬀerences in ﬁscal policies, institutions, and macroeconomic shocks are often large, and the length of time series since the last central bank regime change in most countries is small, particularly for the many countries that adopted inﬂation targeting in the 1990s. Thus, Bernanke, Laubach, Mishkin, and Posen (1999) note that drawing any conclusions from this type of exercise “is diﬃcult and somewhat speculative” (p. 252); Bernanke et al. nevertheless present evidence that inﬂation expectations and inﬂation have come down in inﬂation-targeting countries, and by more than one would have expected ex ante, but in many cases their “control” countries, such as the U.S. and Inﬂation targeting is not synonymous with central bank transparency, but in practice countries that adopted inﬂation targeting in the 1990s at the same time signiﬁcantly increased the amount of information about monetary policy regularly released to the public.
Australia (prior to the adoption of inﬂation targeting), also had similar experiences. The above authors’ evidence is thus suggestive, but is unlikely to convince many of those who may be skeptical. Indeed, Ball and Sheridan (2003) emphasize macroeconomic performance in control countries as well, and come to exactly the opposite conclusion—that once one allows for mean-reversion in inﬂation and other macroeconomic time series, there is no evidence that adopting inﬂation targeting has had any beneﬁts, because countries that adopted inﬂation targeting were exactly those with above-average inﬂation prior to adoption.
The present paper asks a less ambitious question and, as a result, obtains much sharper results. The primary eﬀect of an increase in central bank transparency—deﬁned in this paper as the amount of information about the goals and conduct of monetary policy regularly released to the public—should be an increase in ﬁnancial market and private sector understanding of how the central bank will set policy as a function of the state of the economy. This should lead, ceteris paribus, to an increase in the private sector’s ability to forecast the central bank’s policy instrument: for example, if the central bank were following a Taylor-type rule, rt = r ∗ + πt + ayt + b(πt − π ∗ ), then an improvement in the private sector’s understanding of what values the central bank uses for r ∗, a, b, and π ∗ and exactly how the central bank measures the output gap yt would lead to improved private sector forecasts for rt.2 The present paper investigates to what extent we see such an improvement in ﬁnancial market and private sector forecasts of short-term interest rates in the U.S. over the past 15 years, given the increases in Federal Reserve transparency that took place over that period (Table 1). In particular, we document: 1) an improvement in ﬁnancial markets’ ability to forecast the federal funds rate, 2) a reduction in ﬁnancial market surprises around Federal Open Market Committee (FOMC) announcements, 3) a reduction in ﬁnancial market ex Of course, no central bank follows a policy rule as simple as a Taylor-type rule, but the same reasoning holds for more general mappings from the state of the economy to the policy instrument rt. Discussion of a wide variety of Taylor-type rules can be found in Taylor (1999).
ante uncertainty about the future course of short-term interest rates, as measured by interest rate options, and 4) a fall in the cross-sectional dispersion of private sector forecasts of short-term interest rates. Moreover, we show that there have not been similar improvements in private sector forecasts of real GDP and inﬂation, indicating that private sector forecasts of Federal Reserve policy have improved relative to private sector forecasts of the rest of the economy, strongly suggesting that increases in Federal Reserve transparency have played a role.
A few earlier authors have studied ﬁnancial market forecasts of short-term interest rates in the 1990s. Poole and Rasche (2000) and Poole, Rasche, and Thornton (2002) note that the frequency of days on which federal funds futures rates changed by a large amount (6 basis points or more) decreased from the pre-1994 to the post-1994 period, and that some case studies of federal funds futures behavior around FOMC meetings also suggest that markets have become better able to anticipate FOMC decisions since February 1994.
Lange, Sack, and Whitesell (2003) econometrically document a steady improvement in ﬁnancial markets’ ability to forecast the federal funds rate across three recent subsamples:
pre-1989, 1989–1993, and 1994–2000. The present paper updates the sample period of these earlier studies to include data since mid-2000 and ﬁnds some of their results to be fragile, due to a dramatic deterioration in ﬁnancial market forecast accuracy since January 2001.
This raises two important questions: First, what are the underlying reasons for the recent forecast deterioration? Second, is the forecast improvement prior to 2001 a robust feature of the data, or does it disappear once we control for factors that explain the deterioration since 2001? In other words, if we blame the recent losses in forecast accuracy on increased volatility in the federal funds rate, then do we also have to attribute the earlier gains in forecast accuracy to reductions in federal funds rate volatility, rather than to increases in Federal Reserve transparency? We bring to bear additional ﬁnancial market data, such as implied volatility from interest rate options and panel data from private sector forecasts of output, inﬂation, and interest rates, to help answer these questions.
The remainder of the paper proceeds as follows. In section 2, we show that ﬁnancial market forecasts of short-term interest rates have improved throughout the 1990s by all four measures cited earlier, but that there has been a marked reversal of this trend since January 2001. We show in section 3 that this forecast deterioration is well-explained by recent increases in federal funds rate volatility and uncertainty about the U.S. economy;
controlling for these factors, we continue to see a very signiﬁcant downward trend for all four of our ﬁnancial market forecast measures over the full sample. In section 4, we provide evidence from private sector forecasts of other macroeconomic variables, and from changes in ﬁnancial market uncertainty around FOMC announcements, that increases in Federal Reserve transparency over this period are likely to have been responsible for at least part of the improvement in interest rate forecasts.
2. Financial Market Interest Rate Forecast Accuracy Federal Funds Futures The basic pattern of an improvement in ﬁnancial markets’ ability to forecast shortterm interest rates throughout the 1990s can be seen in Figure 1, which graphs the federal funds futures market’s forecast errors from October 1988 through June 2003.
Federal funds futures contracts have traded on the Chicago Board of Trade exchange since October 1988 and settle based on the average federal funds rate that prevails over a given calendar month.3 The market is liquid, volumes for the current-month and nearfuture (next one to six months) fed funds futures contracts are high, spreads are narrow,
Krueger and Kuttner (1996), Rudebusch (1998), Faust, Swanson, and Wright (forthcoming), and G¨rkaynak, Sack, and Swanson (2002) have shown that federal funds futuresu based forecasts pass standard tests of eﬃciency.
The average federal funds rate is calculated as the simple mean of the daily averages published by the Federal Reserve Board, and the federal funds rate on a non-business day is deﬁned to be the rate that prevailed on the preceding business day. See the appendix for details.
The top panel of Figure 1 plots the absolute value of the 1-month-ahead federal funds futures forecast error, deﬁned to be the realized average federal funds rate for a given month minus the fed funds futures forecast made on the last day of the previous month (e.g., the realized average federal funds rate for June minus the market forecast for June as of May 31). The bottom panel plots the absolute value of the 3-month-ahead market forecast error (e.g., the realized funds rate for June minus the market forecast dated March 31).