The Fed and Interest Rates—A High-Frequency Identification
📄 Summarized from the full manuscript · Human-reviewed for faithfulness before publication
In brief
When the Federal Reserve surprises markets, how far out does the effect reach? This 2002 essay measures surprises from daily interest-rate moves around actual target changes from 1984 to 2001, rather than from monthly statistical models. The whole curve moves together: a one percentage point surprise shifts Treasury yields by 60 to 70 basis points out to three years and still 52 basis points at ten years, where monthly methods suggest long rates barely move. Rates also keep rising for two years afterwards, which the authors call troubling. They present the results as preliminary, resting on few surprises. It matters because it questions whether true policy surprises exist at all.
What this paper finds — and why it matters
This 2002 American Economic Review Papers and Proceedings essay by John Cochrane and Monika Piazzesi proposes a high-frequency alternative to monthly-VAR identification of monetary policy shocks, built from daily interest-rate movements around actual Federal Open Market Committee target-change dates rather than from orthogonalized VAR residuals. Following Piazzesi (2001), they construct two shock measures that are zero in any month without a target change: a “target shock” (the change in a given yield from two days before to one day after a target change, regressed on the target-rate change itself) and a “Eurodollar shock” (the change in the one-month Eurodollar rate over the same window). Using daily U.S. interest-rate data and monthly nonfarm employment, CPI, and commodity-price data over 1984-2001, they estimate two regressions on actual target-change dates (Table 1): the target-shock regression (Panel A) finds coefficients ranging from 0.52 (t=9.1) at the one-month Eurodollar rate down to just 0.19 — 19 basis points (t=3.5) — at ten years; the separate Eurodollar-shock regression (Panel B) fits much better (R-squared as high as 0.87 at three months) and is the source of the paper’s “startling” headline figures — a 1-percent unexpected target change moving Treasury yields by 60-70 basis points from three months to three years and by 52 basis points even at ten years. This produces a “level” effect on the yield curve — all maturities moving together — in sharp contrast to the “slope” effect (short rates moving, long rates barely responding) found using monthly Christiano-Eichenbaum-Evans (CEE, 1996) VAR shocks. A separate forecasting regression (Table 2, 1984-2001, R-squared 0.64) shows Fed target changes are much better predicted by long-term rates than short rates — the two-year rate (b=0.87, t=6.7) and five-year rate (b=-0.87, t=-3.5) dominate — while an earlier, broader version of that regression that included all yields (R-squared 0.66, before variables with small t-statistics were dropped to reach the final Table 2 specification) found the one-month rate contributing almost nothing (b=-0.06, t=-0.8); this pattern implies the Fed reacts to market-embedded inflation expectations and to the yield-curve slope’s real-activity signal, consistent with (but outperforming) a Taylor rule. Two further findings complicate the identification: employment rises, rather than falls, following a high-frequency contractionary shock (versus a slow decline under CEE shocks), a difference the authors trace to how each measure classifies the 1979-1982 episode; and neither shock measure shows a statistically significant inflation decline, with the target-shock measure instead showing a large but “dubiously significant” price-puzzle-like increase. Dynamically, all interest rates keep rising for two years after a shock under the high-frequency measures — the ten-year rate rises 0.8 percentage points versus only 0.2 for the CEE shock — a pattern the authors call “troubling” because it runs against the standard intuition that tight policy lowers long-run inflation expectations and hence long rates. The paper’s own tentative conclusion is that because the Fed’s actions are so often forecastable responses to market information, “perhaps there are no true shocks,” and results throughout are described as preliminary, based on a small number of genuine surprises, and not resting on formal statistical inference beyond the reported coefficients and standard errors.
Summary of a classic paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.
Questions & answers
Q1. How does this paper’s identification strategy differ from the standard monthly-VAR approach to monetary policy shocks?
Instead of orthogonalizing a monthly VAR (as in Christiano-Eichenbaum-Evans 1996, “CEE”), the authors identify shocks only on actual FOMC target-change dates, from daily interest-rate movements around those dates. They construct two measures, both set to zero in months with no target change: a “target shock” (regression of a yield’s change from two days before to one day after the target change on the target-rate change itself) and a “Eurodollar shock” (the change in the one-month Eurodollar rate over the same narrow window). This follows Piazzesi (2001) and avoids imposing the expectations hypothesis. Because the measures condition on realized target changes, many nearly-fully-anticipated target changes generate small or near-zero shocks — the daily approach explicitly separates expected from unexpected policy moves, illustrated by the September 17, 2001 rate cut, which the authors do not count as a shock because markets had already priced it in after the exchanges reopened following 9/11.
Q2. What is the estimated effect of a surprise target change on the yield curve, and how large is it relative to earlier evidence?
Table 1 reports two separate regressions with different-sized coefficients, and the paper’s own “startling” 60-70bp / 52bp figures come from the Eurodollar-shock regression, not the target-shock regression. The target-shock regression (Panel A) — a yield’s change regressed on the target-rate change itself — runs from b=0.52 (t=9.1, R²=0.39) at the one-month Eurodollar rate down to b=0.19 (t=3.5, R²=0.08) at ten years, i.e., a 1-percent unexpected target change moves the ten-year Treasury yield by only about 19 basis points in this regression. The Eurodollar-shock regression (Panel B) — a yield’s change regressed on the one-month Eurodollar-rate change over the same window — fits much better (R-squared as high as 0.87 at the three-month Eurodollar maturity) and produces the larger coefficients the authors call “startling”: b=0.62-0.72 (60-70 basis points) from three months through three years, and b=0.52 (52 basis points) even at ten years. Crucially, both sets of unexpected-change coefficients are far larger and more consistent across maturities than the relation between interest rates and raw (unconditioned) target changes, and together they produce a “level” shift — all maturities moving together — rather than the “slope” effect (short rates react, long rates barely move) that the authors attribute to CEE-style monthly VAR shocks.
Q3. What does the target-forecasting regression imply about how the Fed sets policy?
Long-term rates, not short-term rates, are the dominant predictor of Fed target changes: in the final 1984-2001 forecasting regression (Table 2, R-squared 0.64), the two-year rate (b=0.87, t=6.7) and five-year rate (b=-0.87, t=-3.5) carry most of the explanatory power. The authors reach this specification by starting from a broader regression on all yields (R-squared 0.66) and iteratively dropping the variables with the smallest t-statistics; in that initial, broader regression the one-month Eurodollar rate contributed essentially nothing (b=-0.06, t=-0.8) and does not appear at all in the final Table 2 specification. The authors read the final regression as evidence the Fed responds to inflation expectations embedded in long rates and to the two-year/five-year spread, which forecasts real activity — a pattern consistent with (though not identical to, since the estimated coefficient is well below the Taylor-rule benchmark) a Taylor-type reaction function, and one they say outperforms conventional Taylor-rule specifications in forecasting target changes.
Q4. What is the “employment puzzle,” and why does it arise?
Following a high-frequency contractionary shock, employment rises rather than falls — the opposite of the standard prediction — whereas CEE monthly VAR shocks show employment declining slowly. The authors trace this entirely to how the two approaches treat the 1979-1982 tightening episode: the CEE monthly VAR counts much of that period as large negative shocks, while the high-frequency measure reads most of the 1979-1982 target changes as largely anticipated and therefore assigns them small shocks. They caution that “all of our information about the output effects of monetary policy comes from interpretation of the 1979-1982 experience,” and that neither set of employment responses is statistically significant.
Q5. What do the results say about the effect of policy shocks on inflation?
Neither shock measure delivers a statistically significant inflation decline. The Eurodollar-shock measure agrees with the CEE-based finding that monetary policy has “nearly no effect on inflation,” while the target-shock measure instead shows a large, “dubiously significant” increase in CPI — a price-puzzle-like result — but standard errors are large enough that the authors conclude there is no reliable inflation response either way, which they describe as itself troubling given that tight policy is supposed to lower inflation.
Q6. What is the dynamic “long-rate puzzle,” and what does the paper conclude from it about the very idea of an exogenous policy shock?
In the dynamic (monthly) impulse responses, all interest rates keep rising for roughly two years after a high-frequency shock — the ten-year rate rises 0.8 percentage points versus only 0.2 points under the CEE shock — which the authors call “troubling” because it runs opposite to the intuition that tight policy should eventually lower long rates via lower inflation expectations. They connect this to a broader concern: because Fed target changes are so often forecastable reactions to long-rate and yield-slope information, and because the Fed always frames its actions as responses to economic events rather than arbitrary moves, the authors conclude the paper’s results are preliminary and speculate that “perhaps there are no true shocks” — i.e., that the concept of a genuinely exogenous monetary policy shock may itself be difficult to sustain once policy is understood as reacting systematically to observable information.
Key terms in this paper
Definitions below follow the paper's own usage.
- Target shock (Measure A)
- the paper's primary high-frequency shock — the change in a given interest rate from two days before to one day after an FOMC target-rate change, regressed on the size of the target-rate change itself; equals zero for any month with no target change, so it excludes anticipated-but-not-realized moves that a monthly VAR would otherwise count.
- Eurodollar shock (Measure B)
- an alternative high-frequency shock defined as the change in the one-month Eurodollar rate over the same two-days-before-to-one-day-after window; used because the one-month rate summarizes near-term policy expectations without imposing the expectations hypothesis, and it produces the tightest-fitting yield responses in the paper (R-squared up to 0.87).
- "Level" versus "slope" yield-curve effects
- the paper's terminology for how a shock moves the term structure — a "level" effect moves yields at all maturities together (what the high-frequency shocks produce), while a "slope" effect moves short rates while leaving long rates largely unmoved (what the authors attribute to CEE-style monthly VAR shocks); the distinction is central to the paper's claim that identification method, not just data frequency, drives the estimated transmission of policy to the yield curve.
- Target-forecasting regression
- the paper's estimated Fed reaction function — a regression of target-rate changes on lagged interest-rate levels/spreads (Table 2) — used not to construct a shock but to show that long-term rates and the two-year/five-year spread, rather than short rates, are what best predict the Fed's next move, which the authors interpret as evidence the Fed reacts to information embedded in long rates.
- "Perhaps there are no true shocks"
- the paper's closing methodological caveat — because the Fed consistently explains its actions as responses to economic conditions, and because the high-frequency measures show target changes are frequently anticipated reactions to market information, the authors question whether a cleanly exogenous monetary policy shock can be isolated at all, framing their own estimates as preliminary rather than definitive.