The Response of Term Rates to Fed Announcements

Demiralp and Jorda argue that since the Fed began publicly announcing its Federal funds rate target in 1994, it has manipulated short-term rates through a Pavlovian “announcement effect” – moral suasion backed by a credible threat – requiring far smaller open-market operations than the conventional liquidity effect would predict, and they show, using a new hazard-model decomposition of target changes into anticipated and surprise components, that unanticipated target changes and surprise Fed inaction both move the term structure in ways consistent with the rational expectations hypothesis. The paper’s starting observation is that the February 3-4, 1994 FOMC meeting inaugurated the practice of publicly disclosing the new Federal funds rate target immediately after each meeting, and the authors argue this gave the Fed a genuinely new policy tool distinct from the textbook liquidity effect, in which the Fed moves rates only by manipulating the supply of nonborrowed reserves. Exploiting institutional developments in the reserves market (declining required reserves, retail sweep programs, minimal use of the discount window), the authors show with structural VARs that the estimated liquidity effect is artificially inflated when target-change dates are included in the sample, and that this inflation is much smaller after a 1989 “Thanksgiving effect” episode after which banks began reading Fed intentions with near-certainty – evidence that an announcement/credibility channel was already emerging before the formal 1994 disclosure policy. To measure the effect of target changes on the term structure, the authors build an autoregressive conditional hazard (ACH) model, paired with an ordered-probit model for the size of changes, that decomposes each Federal funds rate target change into its anticipated and unanticipated components without relying solely on the federal funds futures market (which only began in 1989). Regressing Treasury rates of various maturities on these components, they find that anticipated target changes have no significant effect on term rates (as the rational-expectations hypothesis predicts), while unanticipated target changes move rates significantly, an effect that becomes stronger and extends to longer maturities after 1989; strikingly, after 1989 markets also react significantly to surprising Fed inaction – an expected target change that fails to occur – at medium and long maturities, evidence that the market had come to understand and price the Fed’s own reaction function closely enough to be surprised when it did not act as expected.

Selva Demiralp | Macro Paper Warehouse

The Response of Term Rates to Fed Announcements