Kenneth N. Kuttner | Macro Paper Warehouse

Monetary policy surprises and interest rates: Evidence from the Fed funds futures market

This 2001 Journal of Monetary Economics paper by Kenneth N. Kuttner addresses a basic errors-in-variables problem in earlier event studies of monetary policy and interest rates (notably Cook and Hahn 1989 and Roley and Sellon 1995): those studies regressed changes in market interest rates on the raw federal funds target change, without separating the portion markets had already priced in from the portion that came as a surprise, which biases the estimated response toward zero. Kuttner instead uses prices from the Chicago Board of Trade’s Fed funds futures market, established in 1989, to decompose each change in the target rate into an anticipated component and an unanticipated (surprise) component: the surprise is the change in the spot-month futures rate around the announcement, rescaled by a factor that converts from the contract’s monthly-average settlement basis into the point-in-time target-rate unit (and that also cancels out the futures risk premium). He then runs event-study OLS regressions of one-day changes in Treasury bill and bond yields, across maturities from 3 months to 30 years, on the anticipated and unanticipated components separately, using the 42 target changes between June 1989 and February 2000 (22 of them at scheduled FOMC meetings). The central finding is that the anticipated component’s coefficient is small and statistically insignificant at every maturity, while the unanticipated component’s coefficient is large and highly significant, ranging from about 79 basis points at the 3-month maturity down to about 19 basis points at 30 years, with the response declining roughly monotonically across the maturity spectrum; a Wald test rejects equality of the two coefficients at conventional levels for every maturity. By contrast, the naive regression on the raw, undecomposed target change yields only a 27-basis-point response at 3 months, illustrating the scale of the errors-in-variables bias the decomposition removes. The results are robust to restricting the sample to FOMC meeting dates only and to using monthly rather than daily observations, and a companion regression of futures rates at one- to five-month horizons on the same decomposition shows unanticipated-component coefficients clustered between 0.55 and 0.64 that cannot be statistically distinguished across horizons, indicating that a surprise target change mainly shifts the perceived level of the near-term target rather than expectations about further future changes. The paper documents only the interest-rate response to policy surprises and does not trace effects through to output or inflation, and its sample is necessarily confined to the post-1989 period since that is when the Fed funds futures market began trading.

Money, Income, Prices, and Interest Rates

This 1992 American Economic Review paper by Benjamin Friedman and Kenneth Kuttner asks whether money remains a reliable indicator of future nominal and real activity, and whether the predictive failure of monetary aggregates that shows up in post-1980 U.S. data reflects a genuine structural break rather than a fluke of sample choice. Using quarterly U.S. data and reduced-form VAR-based Granger-causality tests (with a uniform four-quarter lag length and no structural identification) plus cointegration tests (ADF residual tests and Johansen maximum-eigenvalue/trace tests), they examine four financial aggregates – the monetary base, M1, M2, and total domestic nonfinancial credit – across three overlapping samples: 1960:2-1979:3 (pre-Volcker), 1960:2-1990:4 (full sample), and 1970:3-1990:4 (post-1970). In the pre-Volcker sample all four aggregates have F-statistics significant for nominal income at the 0.01 level; extending the sample to 1990:4 (1960:2-1990:4) causes the base and credit to lose significance while M1 (3.75**) and M2 (4.49**) remain significant at the 0.01 level, and starting the sample in 1970:3 (1970:3-1990:4) instead eliminates significance for all but a marginal M1 result (2.27, significant only at the 0.10 level) – a pattern that repeats for real income. Cointegration results track the same deterioration: ADF tests find M2 cointegrated with income only in the pre-Volcker sample; Johansen bivariate tests find the base, M1, and credit cointegrated with income pre-Volcker but no aggregate cointegrated in 1970:3-1990:4; and trivariate Johansen tests (money, income, an interest rate) find all four aggregates cointegrated pre-Volcker and none post-1970. Turning to a candidate replacement indicator, the paper shows the commercial paper-Treasury bill rate spread is significant for real income at the 0.05 level or better in every sample and specification, remains significant even when a monetary aggregate is included (at which point the aggregate itself becomes insignificant), and accounts for roughly 23-32% of real income variance in 1960:2-1979:3 and 21-26% in 1970:3-1990:4 in the systems built around the base, M1, or credit (the M2-based system shows a distinctly smaller spread share, around 12-15% and 14-22% respectively); further tests show this predictive power is not just a restatement of the bill rate’s own level, since the bill rate remains independently significant when the spread is included. The authors do not adjudicate between two candidate explanations for money’s failure – 1980s financial deregulation/innovation or the 1979-1982 Volcker disinflation’s change in Fed operating procedure – and they are explicit that all findings are reduced-form predictability results, not structural or causal claims.

The Monetary Transmission Mechanism: Some Answers and Further Questions

This 2002 FRBNY Economic Policy Review article by Kenneth Kuttner and Patricia Mosser is a conference overview, not an original empirical study: it synthesizes papers presented at the Federal Reserve Bank of New York’s April 2001 conference “Financial Innovation and Monetary Transmission” to ask how Fed policy affects the economy and whether financial innovation has changed either the overall strength of monetary transmission or the channels through which it operates. The authors first lay out an “eclectic,” non-exclusive taxonomy of six transmission channels running from open market operations through reserves to the federal funds rate: the interest-rate channel (higher real rates raise the user cost of capital, though the authors note the macroeconomic response to policy-induced rate changes is “considerably larger than that implied by conventional estimates of the interest elasticities of consumption and investment,” pointing to additional channels), the wealth channel (rate changes affect asset values and hence household wealth and consumption), the broad credit or financial-accelerator channel (declining collateral values raise the external finance premium when credit markets have information or agency frictions), the narrow credit or bank-lending channel (reserve changes affect banks’ capacity to lend), the exchange-rate channel (often neglected in closed-economy US models), and the monetarist channel (relative asset-price effects from imperfect asset substitutability, relevant near the zero lower bound). They then identify three measurement challenges that complicate estimating any of these channels: simultaneity (the Fed eases when the economy weakens, so a raw correlation between the funds rate and growth over 1954-2000 is positive at short horizons and only turns negative after roughly a two-quarter lag, with the funds-rate/growth correlation across the whole sample near zero when comparing 1954-83 to 1984-2000 — a pattern consistent with either weaker policy or better stabilization); the difficulty of separating multiple concurrent channels operating together (e.g., disentangling a bank-lending-channel effect from a pure demand effect when both loans and output fall after a tightening); and slow-moving structural change (securitization, disintermediation, and financial consolidation evolved gradually, unlike the abrupt October 1979 operating-procedure shift, making standard structural-break tests poorly suited to detect them). Surveying the conference papers, Kuttner and Mosser report several specific findings attributed to those papers (not to themselves): Boivin and Giannoni’s VAR evidence that the decline in output volatility since the early 1980s reflects mainly a change in the systematic (“leaning against the wind”) component of the policy rule rather than a reduction in the variance of policy shocks, which Kahn-McConnell-Perez-Quiros dispute by attributing reduced output/inventory volatility instead to improved inventory management; Lown and Morgan’s finding that bank lending standards have predictive power for loan volume and output but that monetary policy has little effect on those standards, weakening support for the bank-lending channel; Estrella’s finding that securitization has significantly reduced the sensitivity of output and housing investment to the real funds rate even as mortgage-rate sensitivity to the funds rate has, if anything, increased; McCarthy and Peach’s finding that mortgage rates now respond faster to policy than before 1986 while residential investment responds more slowly and now moves concurrently with (rather than leading) overall activity; and Ludvigson, Steindel, and Lettau’s structural-VAR finding that the wealth channel is weak and, if anything, slightly weaker than in the 1960s-1970s, because asset-price responses to policy shocks are largely transitory and consumption responds mainly to permanent wealth changes. The authors draw three broad conclusions: monetary policy’s effects appear somewhat weaker than in past decades (attributable to financial innovation, better inventory management, and/or improved policy conduct, not to any single cause); the housing sector, once in the vanguard of transmission, now moves concurrently with the broader economy; and neither financial consolidation nor shrinking reserve volumes appear (as of 2002) to be major factors in transmission. They close by flagging three open questions the conference left unresolved: competing (securitization-based versus policy-based) explanations for reduced interest-rate sensitivity remain unreconciled; the causes of changes in securitized lending and housing finance “resist easy explanation”; and no conference paper addressed the exchange-rate channel at all, despite the growing role of net exports in US fluctuations — an explicit gap the authors flag rather than a finding.