Principal investigator: Bruno Benevit
Original title: Policy Language and Information Effects in the Early Days of Federal Reserve Forward Guidance
Author Kurt G. Lunsford
Location of the Intervention: EUA
Sample Size: 51 meetings
Sector: Political Economy
Primary Variable of Interest: Expectations
Type of Intervention: Communication from the Central Bank
Methodology: Study of events
Summary
Agents take into account various pieces of information to formulate their expectations regarding the performance of the economy. The Central Bank plays a crucial role in providing information to agents, indicating optimistic or pessimistic environments for the future. To understand the role of the Federal Reserve (FED) in establishing agents' expectations, this article analyzed how forward-guidance language (forward guidanceThe Federal Open Market Committee (FOMC) of the Fed between 2000 and 2006 shaped private sector expectations regarding the outlook for monetary policy. The evidence found indicated that forward guidance emphasizing risks to the economic outlook causes stronger information effects than forward guidance emphasizing policy inclinations.
- Policy Problem
According to standard macroeconomic theory, forward guidance modulates the expectations of private agents, consequently influencing current economic conditions. In parallel, the actions of central banks have a significant impact on the expectations of economic agents (LUNSFORD, 2020). Central banks have increasingly used forward guidance as a policy tool, commonly referred to as... forward guidance. At the Central Bank of the United States (Federal Reserve – FED), this communication is the responsibility of the Federal Open Market Committee (Federal Open Market Committee's (FOMC). Forward guidance provides communication about the likely future course of interest rates and economic conditions.
In practical terms, Eggertsson and Woodford (2003) describe how the entire path of expected future interest rates influences current economic activity, and that a reduction in this path is expansionary. Added to the evidence that it usually presents better inflation forecasts than private forecasters (ROMER; ROMER, 2000), indicating this information asymmetry as a significant economic friction, the Fed's forward guidance has been interpreted as future changes in the central bank's policy rule that are announced in the present. Given its importance, it is crucial to understand the effects of forward guidance on the expectations of economic agents.
- Policy Implementation Context
The FOMC has used different approaches in forward guidance language to influence private sector expectations. From February 2000 to June 2003, FOMC statements focused on “risks of increased inflationary pressures or economic weakness in the near future,” without directly mentioning future monetary policy inclinations. In this way, this form of communication provided only an economic outlook, without committing to future policy.
However, beginning on August 12, 2003, the FOMC changed its approach by stating that “policy accommodation can be maintained for a considerable period,” introducing direct language about future policy inclinations, which remained until May 2006. This new approach, known as “policy inclination-based” guidance, could alter how the private sector interprets FOMC statements. Instead of merely providing a perspective on economic conditions, the new language could be seen as a commitment to future monetary stimulus. Such a change could result in distinct forward guidance effects, making default effects more predominant and informational effects less relevant.
- Evaluation Details
Beginning with the February 2000 meeting, the Federal Open Market Committee (FOMC) began providing forward guidance on economic risks, covering a period beyond the next meeting. This new communication format was announced in January 2000 and focused exclusively on economic conditions, avoiding mentions of future policy inclinations. The minutes of the December 1999 meeting highlight this absence of references to future policy actions. The author emphasizes that from February 2000 onwards, any reference to future policy actions was considered important, avoiding any direct signal about the monetary policy under consideration (LUNSFORD, 2020). Thus, the forward guidance provided by the FOMC during this period contained only aspects related to the economic outlook. Private sector expectations regarding the federal funds rate were to be endogenous to the FOMC's forward-looking communication and based on its past reaction function, without announcements of changes in the forward policy rule.
On August 12, 2003, the FOMC introduced a significant change by stating that “policy accommodation can be maintained for a considerable period,” the first time it directly referred to future policy inclinations. This change was made to indicate a departure from previous practice, as mentioned in the meeting minutes, which highlighted the intention to maintain accommodative policy for longer than in past periods of accelerated economic activity. Subsequent meetings reinforced this change, with statements indicating a semi-traditional commitment to policy and the manipulation of expectations as a primary tool, especially when near the zero lower bound.
The language of “considerable period” began as an unconventional policy to support the economy, but guidance on policy inclination evolved as the economy strengthened. In January 2004, the FOMC stated that it could be patient in removing policy accommodation. Two months later, in May of the same year, the committee signaled that the removal could be gradual. Over time, statements began to include the possibility of further adjustments as needed, linking these adjustments to evolving inflation and economic growth prospects. This approach was maintained until May 2006, when specific guidance on interest rates was withdrawn, bringing the end of the period under review.
- Method
To measure the impact of FOMC meetings on market participants' expectations, the study considers the trajectory of the expected federal funds rate after the meeting to estimate a surprise parameter for the federal funds rate. The analysis period considers all FOMC meetings between February 2000 and May 2006. For the estimation of the surprise parameter resulting from each meeting, the time horizon considered was between 10 minutes before and 20 minutes after the meetings to determine the manifestation of market participants' expectations of future interest rates based on market asset prices.
The surprise parameter of the federal funds rate was used to estimate an event study model to identify the effect of forward guidance on financial and macroeconomic variables together with the effect of the current federal funds rate. To this end, two orthogonalized policy shocks were created: a surprise in the current federal funds rate and a surprise in forward guidance. The shock in forward guidance is estimated in two steps: first, by measuring the change in the expected path of the federal funds rate, and second, by regressing this change in the current federal funds rate. All analyses were performed considering three periods: from February 2000 to May 2006, from February 2000 to June 2003, and from August 2003 to May 2006.
The financial variables considered were the logarithm of the S&P 500 results, the VIX volatility index, US Treasury yields, term premiums, and expectations for the future path of short-term nominal interest rates. Additionally, the impact on consensus forecasts was observed. Blue Chips Economic Indicators – a collection of macroeconomic forecasts for the United States. Also considered were the yields from corporate bonds, MBS (mortgage-backed securities) rates, and spreads of corporate bonds and mortgages. Finally, the impact on several macroeconomic indicators was verified: the real growth of personal consumption expenditures (PCE), inflation as measured by the CPI, changes in the unemployment rate, and the growth of industrial production (IP).
- Main results
The results regarding the stock market showed that an increase in the current federal funds rate caused a drop in stock prices and an increase in expected volatility (VIX). However, these effects are not statistically significant when considering only the period from August 2003 to May 2006. However, from February 2000 to June 2003, an increase in the path of the federal funds rate resulted in a large increase in stock prices, which is consistent with investors revising their own economic outlook as a result of forward guidance based on the economic outlook. According to the author, the addition of policy tilt language in August 2003 reduced the magnitude of surprises in the current federal funds rate. These results are consistent with those found for the forecasts of... Blue Chip.
With respect to the outcome variables associated with the Treasury during the periods 2000 to 2003 and 2000 to 2006, unexpected changes in the current federal funds rate had a small and statistically insignificant economically significant effect on Treasury yields. treasuries over several years. However, from 2003 to 2006, changes in forward guidance had significant effects on the yield curve. Regarding term premiums, the results showed that term premiums decreased over longer horizons for the sample from 2000 to 2003 and increased over shorter horizons for the sample from 2003 to 2006. The results of the expected path analysis of short-term rates revealed greater sensitivity to forward guidance from 2003 onwards compared to the previous period, as did the results for private credit costs.
Regarding macroeconomic indicators, an increase in the federal funds rate led to unexpected results, such as increased inflation and decreased unemployment, indicating a boost in market confidence during the period from 2000 to 2003. In the period from 2003 to 2006, the change in language in the forward guidance resulted in an expected economic slowdown, with a decline in PCE growth, increased unemployment, and negative growth in industrial production, while inflation did not respond significantly.
- Lessons in Public Policy
This article analyzed how the nature of the FOMC's forward guidance language influences private sector responses to monetary policy statements. Private sector responses to FOMC statements from February 2000 to May 2006 were studied, comparing two periods: February 2000 to June 2003, focused on economic outlook, and August 2003 to May 2006, with the inclusion of policy tilt language.
The results showed that forward guidance emphasizing risks to the economic outlook causes stronger informational effects than forward guidance emphasizing policy inclinations. In the initial period (2000-2003), forward guidance focused on the economic outlook had strong informational effects, leading to positive revisions in market participants' expectations and improvements in economic conditions. In the later period (2003-2006), with the inclusion of policy inclination language, the standard theoretical effects of forward guidance prevailed, resulting in negative revisions of expectations and a worsening of economic conditions. This evidence highlights the importance of clarity and strategy in monetary policy communication, suggesting that how the FOMC communicates its intentions can significantly influence expectations and, consequently, economic conditions.
References
EGGERTSSON, GB; WOODFORD, M. The Zero Bound on Interest Rates and Optimal Monetary Policy. Brookings Papers on Economic Activity, v. 1, p. 139–211, 2003.
LUNSFORD, KG Policy Language and Information Effects in the Early Days of Federal Reserve Forward Guidance. American Economic Review, v. 110, no. 9, p. 2899–2934, 1 Sept. 2020.
ROMER, CD; ROMER, DH Federal Reserve Information and the Behavior of Interest Rates. American Economic Review, v. 90, no. 3, p. 429–457, 1 jun. 2000.
