Responsible researcher: Bruno Benevit
Original title: Policy Language and Information Effects in the Early Days of Federal Reserve Forward Guidance
Author: Kurt G. Lunsford
Intervention Location: USA
Sample Size: 51 meetings
Sector: Political Economy
Variable of Main Interest: Expectations
Type of Intervention: Communication from the Central Bank
Methodology: Event study
Summary
Agents take into account various 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 Bank of the United States (FED) in establishing agents' expectations, this article analyzed how the forward guidance language of the Federal Open Market Committee (FOMC) of the FED between 2000 and 2006 shaped the private sector expectations regarding the monetary policy outlook. The evidence found indicated that future guidance that emphasizes risks to economic prospects causes stronger information effects than future guidance that emphasizes policy inclinations.
According to standard macroeconomic theory, future orientation modulates the expectations of private agents, consequently influencing current economic conditions. At the same time, the actions of central banks have great weight in the expectations of economic agents (LUNSFORD, 2020). Central banks have increasingly used forward guidance as a policy tool, commonly called forward guidance. At the Central Bank of the United States ( Federal Reserve – FED), this communication is the responsibility of the 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 that the entire path of expected future interest rates influences current economic activity and that reducing this path is expansionary. Added to the evidence that it tends to present better inflation forecasts than private forecasters (ROMER; ROMER, 2000), indicating this information asymmetry as an important economic friction, the FED's future guidance has been interpreted as future changes in the policy rule of the central bank that are announced today. Given its importance, it is crucial to understand the effects of future guidance on the expectations of economic agents.
The FOMC has used different approaches to forward guidance language to influence private sector expectations. From February 2000 to June 2003, FOMC statements focused on “the risks of increased inflationary pressures or economic weakness in the near future,” without directly mentioning future monetary policy tilts. In this way, this form of communication provided only an economic perspective, without compromising future policy.
However, beginning on August 12, 2003, the FOMC changed its approach by stating that “policy accommodation may be maintained for a considerable period,” introducing direct language about future policy inclinations, which was maintained until May 2006. This new approach, known as "policy tilt" guidance, could change how the private sector interprets FOMC statements. Rather than just providing an outlook on economic conditions, the new language could be seen as a commitment to future monetary stimulus. Such a change could result in distinct future orientation effects, making standard effects more prevalent and information effects less relevant.
Beginning with its February 2000 meeting, the Federal Open Market Committee (FOMC) began providing forward-looking 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 mention of future policy inclinations. The minutes of the December 1999 meeting highlight this lack of references to future political actions. The author highlights that as of February 2000, any reference to future political actions was considered important, avoiding the manifestation of any direct signal about the monetary policy considered (LUNSFORD, 2020). Thus, the forward guidance provided by the FOMC during this period contained only aspects related to the economic outlook. Private sector expectations about the federal funds rate should be endogenous to the FOMC's perspective communication and based on its past reaction function, without announcements of future policy rule changes.
On August 12, 2003, the FOMC introduced a significant change by stating that “political accommodation may 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 the accommodative policy for longer than in past periods of accelerated economic activity. Subsequent meetings reinforced this shift, with statements indicating a semi-traditional commitment to politics and expectation manipulation as a primary tool, especially when close to the zero lower bound.
The “considerable period” language began as a nontraditional policy to support the economy, but the guidance on political inclination has evolved as the economy has 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 period analyzed to an end.
To measure the impact of FOMC meetings on agents' expectations, the study considers the measure of the expected federal funds rate trajectory after its occurrence to estimate a surprise parameter for the federal funds rate. The analysis period considers all FOMC meetings between February 2000 and May 2006. To estimate the surprise parameter resulting from each meeting, the time horizon between 10 minutes before and 20 minutes after the demonstration meetings was considered. agents' expectations of future rates based on market asset prices.
The federal funds rate surprise parameter was used to estimate an event study model to identify the effect of future 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 the future guidance. The shock to forward guidance is estimated in two steps: first, measuring the change in the expected path of the federal funds rate, and second, regressing this change on the current federal funds rate. All analyzes were carried out 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 bond yields, term premiums, and expectations of the future path of short-term nominal rates. Blue Chips Economic Indicators – a collection of macroeconomic forecasts for the United States – was observed . Corporate bond yields, MBS (mortgage-backed securities) rates, corporate bond spreads Finally, the impact was verified on several macroeconomic indicators: real growth in personal consumption expenditure (PCE), inflation measured by the CPI, variations in the unemployment rate and the growth of industrial production (IP).
Stock market results 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 incurred a large increase in prices of stocks, 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 bias language in August 2003 reduced the magnitude of surprises in the current federal funds rate. Such results are in line with those found for Blue Chip's predictions .
With respect to treasury-associated outcome variables during the periods 2000 to 2003 and 2000 to 2006, unexpected changes in the current federal funds rate had an economically small and statistically insignificant effect on multiyear treasury However, from 2003 to 2006, changes in forward guidance had large effects on the yield curve. In relation to term premiums, the results showed that term premiums presented reductions in longer horizons for the sample from 2000 to 2003 and increases in short horizons for the sample from 2003 to 2006. The results of the analysis of expected path of short-term rates revealed greater sensitivity to future 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 an increase in inflation and a decrease in unemployment, indicating a boost in confidence in the market during the period from 2000 to 2003. In the period from 2003 to 2006, the change The language in the forward guidance resulted in an expected economic slowdown, with falling PCE growth, rising unemployment, and negative industrial production growth, while inflation did not respond significantly.
This article analyzed how the nature of the FED's FOMC 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 prospects, and August 2003 to May 2006, with the inclusion of politically inclined language.
The results showed that future guidance that emphasizes risks to the economic outlook causes stronger information effects than future guidance that emphasizes policy inclinations. In the early period (2000-2003), forward guidance focused on economic prospects 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 tilt language, the standard theoretical effects of future orientation prevailed, resulting in negative revisions of expectations and worsening economic conditions. This evidence highlights the importance of clarity and strategy in communicating monetary policies, suggesting that the way 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 , vol. 1, p. 139–211, 2003.
LUNSFORD, KG Policy Language and Information Effects in the Early Days of Federal Reserve Forward Guidance. American Economic Review , vol. 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 , vol. 90, no. 3, p. 429–457, 1 jun. 2000.
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