The Identification of the Response of Interest Rates to Monetary Policy Actions Using Market-Based Measures of Monetary Policy Shocks

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1 The Idenificaion of he Response of Ineres Raes o Moneary Policy Acions Using Marke-Based Measures of Moneary Policy Shocks Daniel L. Thornon Federal Reserve Bank of S. Louis Phone (314) FAX (314) Address: March 2011 Absrac I has become common pracice o esimae he response of asse prices o moneary policy acions using marke-based measures as proxies for moneary policy shocks, such as he unexpeced change in he federal funds fuures rae. I show ha because ineres raes and marke-based measures of moneary policy shocks respond simulaneously o all news and no simply news abou moneary policy acions, esimaes of he response of ineres raes o moneary policy using such measures are biased. I propose a mehodology ha correcs for his join-response bias. The resuls indicae ha when his bias is accouned for he response of Treasury yields o moneary policy acions is considerably weaker han previously esimaed. JEL Classificaion: E40, E52 Key words: moneary policy shocks, idenificaion, simulaneiy, federal funds arge The views expressed here are he auhor s and do no necessarily reflec he views of he Board of Governors of he Federal Reserve Sysem or he Federal Reserve Bank of S. Louis. I hank Mike McCracken, Ken Kuner, Ellen Meade, Lucio Sarno, Mark Wason, and Giorgio Valene for useful commens and Adiya Gummadavelli and Aaron Alber for helpful research assisance.

2 Moneary policymakers and financial marke paricipans are ineresed in knowing how marke ineres raes respond o Federal Reserve acions. Cook and Hahn (1989) were he firs o esimae he response of Treasury yields o changes in he Fed s arge for he federal funds rae. Specifically, hey regressed daily changes in various Treasury yields on changes in he arge and found ha Treasury raes across he mauriy specrum responded srongly and significanly o changes in he federal funds rae arge during he period Using Cook and Hahn s even-sudy mehodology for he period June 6, 1989, hrough February 2, 2000, Kuner (2001) found a uniformly smaller response of Treasury raes o funds rae arge changes. Noing ha raes, especially longer-erm raes, should only respond o unanicipaed arge changes, he suggesed ha he relaive failure of Cook and Hahn s mehodology in he laer period was likely a consequence of heir failure o differeniae beween expeced and unexpeced arge changes. Following Rudebusch s (1998) suggesion ha federal funds fuures raes provide a naural forecas of he Federal Open Marke Commiee s (FOMC s) arge for he federal funds rae, Kuner (2001) used he change in he federal funds fuures rae on days when he funds rae arge was changed as a proxy for he unexpeced arge change. Since hen, i has become common pracice o esimae he response of ineres raes and oher asse prices o unanicipaed moneary policy acions using marke-based measures of unexpeced moneary policy acions federal funds fuures raes, eurodollar deposi raes, he 3-monh T-bill rae, and eurodollar fuures raes (e.g., Hamilon, 2008; Gürkaynak, Sack, and Swanson, 2007; Faus, Swanson, and Wrigh, 2004; Bomfim, 1

3 2003; Poole and Rasche, 2000; Poole, Rasche, and Thornon, 2002; and Cochrane and Piazzesi, 2002). A number of researchers (e.g., Rigobon and Sack, 2004; Gürkaynak, Sack, and Swanson, 2005; and Craine and Marin, 2008) have recognized ha if ineres raes and he marke-based measures of moneary policy shocks respond simulaneously o news from a variey of sources, and no only news abou moneary policy acions, he esimaed response of asse prices o moneary policy acions using marke-based measures of moneary policy shocks will be biased and inconsisen. Rigobon and Sack (2004) noe ha he even sudy approach essenially assumes ha essenially he only hing moving raes on days when here are policy acions is he surprise policy acion. They propose o idenify he effec of he policy acion using a procedure called idenificaion hrough heeroskedasiciy. Specifically, hey assume he variance of moneary policy shocks is larger on days when here are FOMC meeings and he Chairman s semi-annual esimony han on oher days. The mehodology purposed here correcs wihou making arbirary assumpions abou when he variance of moneary policy shocks is large. Specifically, i uses he marke-based measure on all days as a laen variable o accoun for he relaionship beween asses prices and he marke-based measure of moneary policy shocks on days when here are unexpeced policy acions. The mehodology permis one o idenify he marginal effec of moneary surprises relaive o nonmoneary shocks. The mehodology is simple o employ and requires a simple idenifying assumpion. Moreover, i is easily modified o accoun for he effecs of oher evens such as he marke s reacion o oher headline news. 2

4 The resuls show ha, when he join-response bias is accouned for, he response of Treasury raes is considerably smaller han previously repored. For daa prior o February 3, 2000, he marginal response of yields on Treasury securiies wih mauriies of one year or less is abou half of ha obained using he sandard mehodology, and hose wih mauriies longer han a year here is no saisically significan response beyond he response o ambien news. For daa afer February 2, 2000, none of he Treasury raes respond significanly o unanicipaed moneary policy acions. The remainder of he paper is divided ino five secions. Secion 2 analyses he response of ineres raes o news. Cook and Hahn s (1989) even-sudy mehodology and Kuner s criique and refinemen of his mehodology are presened in Secion 3. Secion 4 shows why marke-based measures of moneary policy shocks yield biased esimaes of he response of ineres raes o moneary policy shocks. Secion 5 presens a laenvariable mehodology and compares he resuls using his and sandard mehodology. The conclusions are presened in Secion The Response of Ineres Raes o News There have been any number of empirical invesigaions of he response of ineres raes (or oher asses prices) o headline news (e.g., Remolona and Fleming, 1999; Fleming and Remolona, 1999; and Barolini, 2008). Because he FOMC has been argeing he federal funds rae, much of his research has focused on news abou moneary policy (e.g., Gürkaynak e al., 2005; and Bernanke and Kuner, 2005). Evensudy research has focused on headline news evens; however, ineres raes and oher asse prices respond o news from a wide variey of sources. Because his informaion is 3

5 no easily idenified, i is difficul if no impossible o associae a given response wih a paricular piece of news or even. I call such informaion ambien news. This secion analyzes he relaionship beween Kuner s (2001) marke-based moneary policy shock measure and changes in Treasury raes on all days, no only days when he funds rae arge is changed. 1 Kuner s (2001) marke-based moneary shock measure is primarily based on he spo, or curren-monh, federal funds fuures rae. The federal funds fuures rae is he rae on a derivaive conrac whose value depends on he average level of he effecive federal funds rae in he monh of he conrac. Consequenly, he marke s expecaion for he average of he effecive funds rae over he monh on he h day of he monh is given by (1) where 1 m 0 1 k k k 1 k fff m ff ( 1) E ff ( m 1), 0 fff denoes he rae on he curren-monh federal funds fuures conrac, ff denoes he effecive (overnigh) federal funds rae, and m denoes he number of days in he monh. Tha is, he fuures rae is simply a weighed average of he observed funds rae up o day and he marke s expecaion of he funds rae over he remainder of he monh. If he marke expecs he FOMC o change is arge on day, bu no again during he monh, hen fff fff would be zero. Hence, a naural way o esimae he moneary policy surprise is (2) * u m 0 0 ff ( fff fff 1). m 1 Piazzesi and Swanson (2008) argue ha federal funds fuures rae measures of financial markes expecaions of moneary policy may be biased because of a risk premium. They find, however, ha Kuner s (2001) measure appears o be relaively robus o risk premia in federal funds fuures conracs, noing ha The difference-based measure may largely difference ou risk premia ha are moving primarily a lower, business-cycle frequencies (Piazzesi and Swanson, 2008, p. 690). 4

6 Aware ha his measure could no be calculaed on he firs day of he monh, Kuner replaced fff wih he 1-monh-ahead federal funds fuures rae on he las day of he 0 1 previous monh. He also noed ha here were problems wih his measure on he las few days of he monh, so he used (3) where ff ( fff fff ), * u fff denoes he rae on he 1-monh-ahead federal funds fuures conrac on he las hree days of he monh. 2 Kuner (2001) calculaed *u ff only for days when he FOMC changed is arge for he funds rae and pariioned arge changes ino expeced and unexpeced arge. Specifically, (4) where * e * * u * m 0 0 ff ff ff ff ( fff fff 1), m * ff denoes he change in he funds rae arge and *e ff denoes he expeced arge change. Noe ha *u ff can be calculaed for any day of he monh; however, he expeced componen of acual arge changes can be calculaed only on days when he arge is changed. Alhough he analysis presened here focuses on Kuner s federal funds fuures rae policy shock measure, i applies o all marke-based measures of moneary policy shocks used in he lieraure. 2 Poole and Rasche (2000) and Poole e al., (2002) used equaion (3) exclusively as heir measure of he moneary policy shock. The resuls presened here are qualiaively he same when Poole and Rasche s (2000) measure is used. 5

7 3. Esimaing he Response of Ineres Raes o Moneary Policy Acions Cook and Hahn (1989) esimaed he response of Treasury raes o moneary policy acions by esimaing he equaion (5) where * i ff, * ff denoes he FOMC s arge for he federal funds rae and i denoes one of several Treasury raes. 3 They found ha he esimae of was very close o 0.50 for he 3-, 6-, and 12-monh T-bill raes, and ha he esimaes of hen declined monoonically o for he 20-year bond yield as he erm o mauriy increased. Esimaes of were highly saisically significan for all raes, and esimaes of 2 R ranged from 59 o 29 percen. Kuner (2001) esimaed equaion (1) over he period June 6, 1989, hrough February 2, 2000, and found ha he reacions of ineres raes o a change in he funds rae arge were uniformly smaller and less significan han hose for he sample period. Moreover, here was no saisically significan response for long-erm yields. Rejecing as implausible ha his resul could be due o marke paricipans being unaware ha he Fed was argeing he funds rae because of he Fed s greaer ransparency, Kuner (2001) suggesed ha a more likely explanaion is ha arge rae changes have been more widely anicipaed in recen years. 4 Specifically, he suggesed ha Cook and Hahn s (1989) even-sudy mehodology failed o disinguish beween anicipaed and unanicipaed arge changes, which produced noise and resuled in an 3 Cook and Hahn (1989) did no use he acual change in he funds arge because he magniude and iming of hese changes were unknown. Raher, hey deermined when he funds rae arge had changed from press repors in he Wall Sree Journal. 4 Kuner (2001, p. 526). 6

8 aenuaed esimae of ineres raes response o policy surprises. 5 He suggesed ha he bias could be eliminaed by using he federal funds fuures rae o proxy for he unexpeced componen of he arge change. Specifically, he suggesed ha he response of ineres raes o a moneary policy shock could be deermined by esimaing (6) *u i ff, on days when he FOMC changed is arge for he funds rae. 4. The Join-Response of Treasury Raes and Kuner Shocks I is easy o demonsrae ha he esimae of he response o unexpeced policy acions from equaion (6) will be biased if he marke-based measure responds o informaion oher han moneary policy acions. Consequenly, i is imporan o show ha Kuner s policy shock measure responds o news oher han news abou moneary policy acions. This is demonsraed in Table 1, which shows he correlaions beween Kuner s measure and eigh Treasury raes on days when here were no changes in he funds rae arge. The sample period is June 6, 1989, hrough February 2, 2000, and he Treasury raes are he 3- and 6-monh T-bill raes (b3 and b6) and he 1-, 3-, 5-, 7-, 10-, and 20-year Treasury bond yields (1, 3, 5, 7, 10, and 20). The second column of Table 1 shows ha Treasury raes and Kuner shocks are srongly correlaed on days when he funds rae arge was no changed. Hence, Kuner s shock measure responded o whaever he news moved Treasury raes on hose days. Because he federal funds fuures rae reflecs he marke s expecaion of he fuure monhly average effecive funds rae, some migh argue ha he correlaions on days when here is no arge change merely reflec he marke s expecaion of fuure 5 Kuner (2001, p. 527). 7

9 policy acions no he join response o ambien news. Indeed, under a sric funds rae argeing procedure he monhly he funds rae should equal he funds rae arge on average over he monh. However, if he fuure raes only responded o acual or expeced fuure policy acions, he correlaions should be higher on days when here are relaively large Kuner shocks because revisions of marke paricipans expecaions abou he FOMC s funds rae arge should occur relaively infrequenly and be associaed wih relaively large Kuner shocks. This is no he case, however. Columns 3 hrough 6 of Table 1 presen he correlaions for subsamples based on he absolue magniude of Kuner shocks. The magniude of he correlaions is robus o he size of he shocks and are highly correlaed even when * u ff is less han 2.5 basis poins. Some migh sugges ha because he FOMC was argeing he funds rae, he federal funds fuures rae should only respond o surprise moneary policy acions. This suggesion ignores he fac ha here was considerable uncerainy abou he exen o which he FOMC was argeing he funds rae and he precise level of he funds rae arge during much of he June 6, February 2, 2000, sample period. This uncerainy diminished over ime; however, as discussed below, he uncerainy was no compleely resolved unil February Thornon (2006a) shows ha alhough he FOMC effecively reurned o a funds rae operaing procedure in Sepember 1982, officially, he FOMC mainained i was argeing borrowed reserves. 6 Indeed, unil he mid-1990s, he FOMC remained ambiguous abou he exen o which i was argeing he funds rae. For example, a he conclusion of is February 1994 meeing, when he FOMC 6 See Thornon (2006a) for several reasons why he FOMC preferred o be seen as argeing borrowed reserves raher han he funds rae. 8

10 began he pracice of announcing policy acions, he funds rae was no menioned. The saemen read, he Federal Open Marke Commiee decided o increase slighly he degree of pressure on reserve posiions. The acion is expeced o be associaed wih a small increase in shor-erm money marke ineres raes. 7 Prior o February 1994, marke paricipans did no have complee knowledge of he exen o which he FOMC was using he federal funds rae as a policy insrumen. Moreover, mos arge changes occurred beween FOMC meeings and he marke had o infer wheher he FOMC had aken a policy acion from signals ha he Trading Desk of he Federal Reserve Bank of New York (hereafer, Desk) provided in conducing daily open marke operaions (e.g., Feinman, 1993). 8. Over ime, he FOMC became increasingly open abou he exen o which i was relying on he funds rae o implemen moneary policy and abou he level of he arge. For example, when i reduced he funds rae arge by 25 basis poins in July 1995, he FOMC s saemen read, he Federal Open Marke Commiee decided o decrease slighly he degree of pressure on bank reserve posiions oday s acion will be refleced in a 25 basis poin decline in he federal funds rae from abou 6 percen o abou 5-3/4 percen. 9 The FOMC did no officially announce i was argeing he funds rae unil December 21, 1999, when i announced ha The Federal Open Marke Commiee made no change oday in is arge for he federal funds rae. 10 Ambiguiy abou he level of he arge was no compleely eliminaed unil he February 2, 2000, FOMC saemen 7 Board of Governors (1994), emphasis added. 8 The classic case of misinerpreing he Desk s signal occurred he day before Thanksgiving 1989, when marke analyss misinerpreed he Desk s acion as a signal he Fed had eased policy. 9 Board of Governors (1995), ialics added. 10 Board of Governors (1999), ialics added. 9

11 which read: The Federal Open Marke Commiee voed oday o raise is arge for he federal funds rae by 25 basis poins o 5-3/4 percen. 11 Ambiguiy abou he funds rae arge is refleced in he behavior of he funds rae relaive o he arge. Figure 1 presens he absolue daily difference beween he funds rae and he funds rae arge from Sepember 6, 1989, hrough June 29, Daily differences of he funds rae from he arge were very large prior o The average absolue difference was 14 basis poins before 2000 and only 5 basis poins afer. The large daily differences of he funds rae from he arge are also refleced in monhly average daa presened in Figure 2. Prior o 2000 he monhly average difference was 5 basis poins or larger for one-hird of he monhs. In conras, differences his large occurred for only 3.0 percen of he monhs from 2000 on. Given his uncerainy and he fac ha he funds rae could deviae significanly from he FOMC s arge, i is no difficul o undersand why he federal funds fuures rae migh also respond o news ha would affec ineres raes more generally. Afer 2000, he marke no only knew he precise level of he FOMC s funds rae arge, bu Chairman Greenspan frequenly signaled he magniude of he nex arge change. Given he relaively small daily and monhly average differences beween he funds rae and he arge afer 2000, i seems unlikely ha Kuner shocks on days when he arge was unchanged would reflec informaion oher han he marke s expecaion of a change in he arge. 11 Board of Governors (2000). 10

12 4.1 The Join-Response Bias This secion shows why he esimae of from equaion (6) is biased when he marke-based proxy for unexpeced policy acions responds o ambien news. To see why, le u ff denoe he unexpeced arge change, which is sricly unobservable, and * fff denoe he marke-based proxy for he unexpeced arge change. Now assume ha he marke-based measure response o ambien news ( i.e., N ) and he unexpeced arge change, (7) fff N ff. u * where and denoe he response of he marke-based measure o ambien news and unexpeced arge changes, respecively, and v denoes an idiosyncraic shock o he marke-based measure. Now assume ha he ineres rae of ineres also responds o ambien news and unexpeced arge changes, i.e., (8) i N ff. u * where and denoe he response of he Treasury rae o ambien news and unexpeced arge changes, respecively, and denoe idiosyncraic shock o he Treasury rae. Noe ha 0 on days when he arge is no change or if he Fed s acion is fully anicipaed. Subsiuing equaion (8) ino equaion (7) yields (9) i N ff. * ( u ) I is easy o show ha (10) 2 2 N u * ff N u * ff P lim ˆ, 11

13 where 2 2 u ff N and * denoe he variance of ambien news and unexpeced arge changes, respecively. Equaion (10) shows ha he esimae of from equaion (6) correcly idenifies he response of he ineres rae o an unexpeced arge change if and only if 0. If his were he case, fff ff so ha response of he ineres rae u * o an unexpeced arge change could be idenified up o scalar, i.e., P lim ˆ / he relaive response of he ineres rae and he fuures rae o an unexpeced change in he funds rae arge. If 0 ; however, esimaes of from equaion (6) will be biased. 12 Indeed, he esimae of could be nonzero even if he Fed s acion was fully anicipaed, i.e., 0. Noe ha his bias arises because, while he ambien news shocks and unexpeced moneary policy shocks are orhogonal, he response of he marke-based policy measure a he daily frequency reflecs he response o boh shocks and no simply he moneary policy shocks. 5. Correcing for he Join-Response Bias Gürkaynak, Sack, and Swanson (2005) propose dealing wih he join-response bias by using daa are measured over a ime inerval ha is sufficienly shor ha i is much less likely ha any oher significan evens ook place wihin his narrow window ha migh have influenced asse prices. 13 Using exremely high-frequency daa significanly reduces, if no eliminaes, he join-response bias; however, he esimaed response using his daa migh oversae he effec of Fed acions on ineres raes over he day. For example, Gürkaynak, Sack, and Swanson (2005) noe ha 12 Esimaes from equaion (6) could also suffer from simulaneous equaion bias. For example, for a period during he early 1990s he funds rae arge was changed shorly afer he Bureau of Labor Saisics released he employmen repor, igniing speculaion ha he FOMC was responding o he employmen repor. 13 Gürkaynak, Sack, and Swanson (2007), p

14 The Federal Reserve s announcemen following is January 28, 2004, policy meeing led o one of he larges reacions in he Treasury marke on record, wih wo- and five-year yields jumping 20 and 25 basis poins (bp) respecively in he half-hour surrounding he announcemen he larges movemens around any Federal Open Marke Commiee (FOMC) announcemen over he foureen years for which we have daa. Alhough he immediae reacion o his announcemen was excepional, he changes in hese raes over he day were much less so. The daily changes in hese raes were 17 and 15 basis poins, respecively. Daily changes in oher Treasury raes were smaller; for example, he 10- and 20-year yields changed by 11 and 10 basis poins, respecively. These daily changes are no paricularly unusual: On 267 days of he sample (6 percen) he 10-year Treasury yield changed by 11 basis poins or more and on 135 days he 5-year yield changed by 15 basis poins or more. Consequenly, using exremely high-frequency daa may give a disored picure of he exen o which ineres raes respond o moneary policy shocks on he day. Moreover, mos of he even-sudy lieraure has used daily daa, which is more readily available. Alernaively, Rigobon and Sack (2004) and Craine and Marin (2008) use a mehodology ha relies on he variance-covariance marix o achieve srucural idenificaion in a simulaneous equaion seing. However, he procedure relies on relaively srong assumpions abou he relaive variance of moneary policy shocks o oher shocks. In conras, he procedure described below only requires ha all ineres raes o news on all days regardless of wheher here are moneary policy surprises or oher headline news an assumpion ha is easily verified. The join-response bias exiss because ineres raes and marke-based moneary policy shock measures respond o all informaion relevan o ineres raes. Hence, i is 13

15 necessary o accoun for his bias in order o idenify he effec of surprise moneary policy acions on ineres raes. This can be done by using he marke-based measure of a moneary policy shocks as a laen variable ha accouns for he marke s reacion o ambien news. Specifically, i can be achieved by esimaing (11) where i TC ff ff TC, * * ( ) n u mps u ( ) *u ff denoes Kuner s marke-based measure of unexpeced arge changes, TC denoes a dummy variable ha is 1.0 on days when he FOMC changed he funds rae arge and zero oherwise, n denoes he join response of ineres raes and markebased measures of moneary policy shocks o ambien news, and mps denoes join response of he ineres rae and he marke-based measure o unexpeced arge changes. Noe ha mps measures he marginal change in he ineres rae associaed wih unexpeced policy acion. If mps is no significanly differen from zero, he marke s reacion o a surprise moneary policy acion is no differen from is reacion o ambien news surprise moneary policy acions have no unique effec on ineres raes. Noe oo ha n represens he size of he bias of he esimae of from equaion (6), i.e., i is an esimae of he join-response bias. 5.1 The Response of Treasury Raes o Moneary Policy Shocks The iniial invesigaion of he effec of he join-response bias uses Kuner s (2001) sample period, June 6, February 2, A comparison of he sample sizes across he columns of Table 1 reveals ha here are a small number of unusually large Kuner shocks during he sample period. Specifically, here were 26 shocks ha were 30 basis poins or larger in absolue value; however, one of hese occurred on a day when he 14

16 arge was changed. 14 All bu one of he remaining 25 unusually large shocks occurred early or lae in he monh, ended o be clusered, and were no associaed wih unusually large changes in Treasury raes (see Appendix B for deails). These characerisic sugges ha hese unusually large Kuner shocks are idiosyncraic o he federal funds fuures marke. Given hese facs and he sensiiviy of ordinary leas squares esimaes o exreme observaions, hese 25 unusually large Kuner shocks were excluded from he sample. 15 The analysis begins by esimaing Kuner s (2001) equaion, (12) i ff ff ff, * u ( * * u ) 1 2 for each of eigh Treasury raes. 16 These esimaes are repored in Table 2. The able presens he parameer esimaes, he corresponding p-values, as well as esimaes of and he sandard error, SE. 17 The esimaes are similar o hose repored by Kuner 2 R (2001). None of he esimaes of 2 is saisically significan, indicaing ha anicipaed policy acions are already refleced in raes. In conras, all of he esimaes of are 1 posiive and saisically significan, indicaing ha surprise moneary policy acions have a srong posiive effec on ineres raes across he erm srucure. The esimaed response of he 3- and 6-monh T-bill raes are much larger han hose obained by Cook and Hahn (1989) and he esimaes decline monoonically as he erm o mauriy lenghens. 14 This occurred on July 2, The qualiaive conclusions are robus o wheher hese observaions are included or excluded. 16 The Kuner shocks on days when he funds rae arge changed used here differ on a few occasions from hose used by Kuner (2001). The differences are wofold. Firs, he daes of arge changes are from Thornon (2006a), and differ from Kuner s on hree days. There were also six days when he values are differen, apparenly because of differences in he fuures raes used here and hose used by Kuner (2001). Appendix A shows he Kuner shocks used here and Kuner s (2001) shocks. In any even, hese small differences are no imporan for he qualiaive resuls presened here. 17 The covariance marix for his and all oher equaions repored in his paper were obained using a heeroskedasiciy and auocorrelaion consisen esimaor. 15

17 The effec of he join-response bias is invesigaed by esimaing equaion (11). The esimaes, presened in Table 3, show ha sum of he esimaes of n and mps for each rae is somewha smaller han he corresponding esimae of 1 in Table 2; however, he null hypohesis ˆ n ˆ mps ˆ 1 canno be rejeced a any reasonable significance level for any of he eigh raes. Consisen wih he join response o ambien news, esimaes of n are posiive and highly saisically significan for all raes. In conras, esimaes of mps are saisically significan only for Treasuries wih mauriies of one year or less. For mauriies beyond one year, here is no saisically significan effec of a surprise arge change beyond he join response o ambien news. Moreover, esimaes of from 1 equaion (12) are saisically significanly larger han he corresponding esimaes of mps, reflecing he upward bias in esimaes of policy shocks ha can arise from using marke-based measures of moneary policy shocks. 5.2 Ambien News or Expecaions of Fuure Targe Changes? The analysis in Secion 4 suggess several reasons why he relaionship beween he federal funds fuures rae and Treasury raes on days when here no changes in he funds rae arge is a consequence of he marke s reacion o ambien news. Neverheless, he possibiliy ha his relaionship reflecs expecaions of fuure arge changes is invesigaed in wo ways. Firs, several analyss (e.g., Rudebusch, 1998; Bernanke and Kuner, 2005; and Gürkaynak e al., 2007) have suggesed he possibiliy ha he FOMC responded o he employmen repor. Moreover, here is evidence ha he bond marke responds o headline economic announcemens (e.g., Fleming and 1999; and Balduzzi e al., 2001). Indeed, 17 of he 42 arge changes during he sample period occurred on 16

18 days when here where headline news announcemens days (see Appendix C for a lis of he headline news announcemens used here). Consequenly, marke paricipans migh be more inclined o revise heir expecaions of he likelihood of a fuure moneary policy acion on headline-news-announcemen days han on oher days. If changes in he federal funds fuures rae reflec changes in he marke s expecaion of fuure policy acions, he response of ineres raes o Kuner shocks should be larger on headline-newsannouncemen days han on oher days. This implicaion is invesigaed by esimaing he equaion, (13) i TC hl ff ff hl ff TC, * * * ( ) ( ) n u hl u ( ) mps u ( ) where hl is a dummy variable ha is equal o 1.0 on days when here is headline news announcemen bu no change in he funds rae arge and zero on all oher days. If he federal funds fuures and Treasury raes are responding o expecaions of fuure arge changes, esimaes of h should be posiive and saisically significan. Esimaes of Equaion (13) are presened in Table 4. Only he esimaes of n, hl, and mps are presened, along wih he summary saisics. Esimaes of hl are posiive for all eigh ineres raes; however, he esimaes are no saisically significan a he shor end of he yield curve, where he effec of a surprise arge change is relaively large and saisically significan. Hence, i is difficul o inerpre he saisically significan esimaes of hl for mauriies of hree years or longer as being caused by expecaions of fuure arge changes. Imporanly, he esimaes of mps differ only slighly from hose repored in Table 3. The second invesigaion is moivaed by he FOMC s asymmeric policy direcive. From 1983 hrough 1999 he FOMC s policy direcive conained language 17

19 widely hough o indicae he likelihood of a policy acion before he nex regularly scheduled FOMC meeing. 18 The direcive was said o be symmeric if he direcive indicaed ha ighening or easing were equally likely in he fuure and asymmeric oherwise. Evidence indicaes ha inermeeing policy acions occurred more frequenly and were somewha larger under an asymmeric policy direcive, (e.g., Thornon and Wheelock, 2000) The symmery of he FOMC s policy direcive was known when he FOMC minues where released. During his period he minues were released abou wo o hree weeks afer he nex FOMC meeing. Consequenly, as a general rule, marke paricipans did no know he symmery of he policy direcive ha was operaional a he ime. However, Belongia and Kliesen (1994) documen 11 occasions beween early 1983 and May 1993 when informaion abou he curren policy direcive was leaked in he press. Furher analysis shows ha on hree of hese occasions, he leak conained informaion abou he asymmery of he FOMC s policy direcive. These leaks, repored in he Wall Sree Journal, occurred on Augus 27, 1990, Ocober 3, 1991, and May 24, Hence, from he dae of he leak o he nex meeing of he FOMC, marke paricipans knew he asymmery of he FOMC s policy direcive. To furher invesigae wheher Kuner shocks on days wih no arge changes migh reflec marke paricipans expecaions of fuure policy acions, he equaion (14) i TC lk ff ff lk ff TC n * u lk * u mps * u ( ) ( ) ( ) ( ) 18 This direcive was replaced by he balance of risk saemen in January See Thornon and Wheelock (2000) for deails. 18

20 is esimaed. lk is a dummy variable ha akes on he value 1.0 on days when he marke knew he asymmery of he FOMC s policy direcive and zero oherwise. 19 Esimaes of equaion (14) are presen in Table 5. Esimaes of lk are negaive for mauriies of one year or less and posiive for mauriies of more han one year. However, he only esimae ha is saisically significan is for he 3-monh T-bill rae. As wih headline news, none of he esimaes of mps is significanly differen from hose repored in Table 3. The resuls in Tables 4 and 5 are consisen wih he idea ha esimaes of n are he consequence of he join-response of Treasury raes and he federal funds fuures rae o ambien news, raher han he response o changing expecaions of he FOMC s funds rae arge. 5.3 The Response o Moneary Shocks Since 2000 By 2000 he FOMC funds arge rae was well known. So oo was he FOMC s pracice of changing he arge a regularly scheduled meeings, excep in unusual circumsances and Chairman Greenspan s pracice of frequenly signaling arge changes a few days in advance of he meeing. Consequenly, here were fewer surprise arge changes han during he prior sample period. This is refleced in he Kuner shocks on days when he funds rae arge was changed, which are presened in Table 6. Wih he excepion of he hree inermeeing arge changes ha occurred January 3, April 18, and Sepember 17, of 2001, and November 6, 2002, when he marke was expecing a 25- basis-poin reducion in he arge rae and he FOMC reduced he arge by 50 basis poins, Kuner shocks are relaively small. The lack of large Kuner shocks is paricularly pronounced afer mid-2004: Afer May 2004 here are no Kuner shocks 19 Specifically, he dummy variable is one from he dae of he leak o dae of he nex FOMC meeing. 19

21 larger han 3 basis poins in absolue value. In May 2004 he FOMC adoped he measured pace language in is press saemen. This language was widely regarded as indicaing ha he FOMC would increase he funds rae arge by 25 basis poins a he nex meeing. The FOMC fulfilled his expecaion a each of he nex 14 meeings. 20 The language was modified a he December 2005 meeing and disconinued a he January 2006 meeing. There were hree arge changes afer January 2006, all of which were signaled well in advance of he acion. I is also he case ha here were 13 days when he absolue value of he shock was greaer han or equal o 20 basis poins on days when he arge was no changed. As during he earlier sample period, hese unusually large Kuner shocks ended o occur oward he beginning or end of he monh and were no generally associaed wih large changes in he Treasury raes. Moreover, six occurred afer he 9/11 erroris aacks in Sepember 2001 (see Appendix D for deails). These 13 observaions are excluded in he analyses presened below. Esimaes of Kuner s equaion (equaion, 12) for he period February 3, 2000, hrough June 29, 2007, are presened in Table 7. The esimaes of 1 are much smaller han hose repored in Table 2: Esimaes of 1 for Treasury raes wih mauriies from 3 monhs o 1 year are abou half as large as hose for he prior sample period. Moreover, esimaes of he response of Treasury s wih mauriies longer han a year are saisically insignifican differen from zero, suggesing ha surprise policy acions had no significan effec on longer-erm yields. 20 See Thornon (2006b) for a discussion of he measured pace language. 20

22 Esimaes of equaion (11) are presened in Table 8. All of he esimaes of n are posiive and highly saisically significan, indicaive of he join response of Treasury raes and Kuner shocks o ambien news. As before, esimaes of he response of Treasury raes o moneary policy shocks from equaion (12) are essenially he sum of n and mps from equaion (11). However, none of he esimaes of mps is saisically significan a he 5 percen level excep ha for he 20-year Treasury yield, which is negaive. The negaive esimae suggess ha he 20-year yield migh reflec a revision of long-erm inflaion expecaions. The srong and saisically significan relaionship beween Kuner shocks and changes in Treasury raes on days when here were no policy acions migh be surprising given ha he FOMC s funds rae arge was well known and arge changes principally occurred a FOMC meeings. These facs would seem o sugges ha he federal funds fuures rae should respond only o unexpeced policy acions and no o ambien news. I is imporan o remember ha while he daily and monhly average deviaions of he federal funds rae from he funds rae arge were significanly smaller afer early 2000, hey were no zero (see Figures 1 and 2). Moreover, as noed in Table 1, he srengh of he relaionship beween Kuner shocks and changes in Treasury yields is essenially independen of he size of he Kuner shock. Hence, ambien news could effecs boh he fuures rae and Treasury raes in much he same way as during he prior period, even hough he absolue value of he effecs was small. Neverheless, knowledge of he FOMC s funds rae arge and when he arge was mos likely o change appears o have affeced he esimae of he response of Treasury raes o ambien news. Given he FOMC s argeing procedure, i is unlikely 21

23 ha marke paricipans would revise heir expecaion of a arge changes daily. Consequenly, he response of he federal funds fuures rae o ambien news should be mued relaive o he response of marke raes. This is illusraed in Figure 3, which presens he disribuions of Kuner shocks, 1 and 10 for he sample periods June 6, February 2, 2000, and February 3, June 29, 2007, on days wih no arge changes. The disribuion of Kuner shocks becomes significanly more lepokuric during he mos recen sample period and he sandard deviaion declines by more han 50 percen from he earlier period from o In conras, he disribuions of he 1- and 10-year bond yields are essenially unchanged: The sandard deviaion of he 1-year yield declines by abou 20 percen while ha of he 10-year yield declines by less han 1 percen. The mued response of he federal funds fuures rae o ambien news resuls in larger esimaes of n he change in he Treasury rae per percenage poin change in Kuner shocks is larger. 5.4 Ambien News or Expecaions of Fuure Targe Changes? The resul ha surprise policy acions had lile or no effec on Treasury raes could also occur if arge changes were anicipaed. To invesigae his possibiliy, equaion (11) was esimaed for he period February 3, 2000, hrough December 31, 2003, a period when relaively large moneary policy shocks were more numerous. The resuls (no presened here) are qualiaively he same as hose presened in Tables 7 and 8, suggesing ha he resul may no be due solely o he fac ha policy acions were anicipaed. Neverheless, i is imporan o noe ha only 7 of he 16 moneary policy shocks during his sample period were 10 basis poins or larger. Consequenly, i is 22

24 difficul o draw any firm conclusion abou he exen o which he resuls over his period were affeced by beer expecaions of funds rae arge adjusmens. 6. Conclusion Following Kuner s (2001) use of he federal funds fuures rae o measure moneary policy shocks, i has become common o invesigae he response of asse prices o unanicipaed moneary policy acions using marke-based measures of moneary policy shocks. This mehodology is shown o yield biased esimaes of he response of asse prices o moneary policy shocks when marke-based measures of moneary policy shocks respond o news oher han surprise moneary policy acions. This bias can be accouned for by esimaing he equaion for all days in he sample and no merely days when here is a policy acions. In so doing, he marke-based measure of moneary policy shocks is effecively a laen variable ha accouns for he relaionship beween asse prices and he marke-based measure of moneary policy shocks ha arises because marke prices and yields respond o he same informaion each day. A comparison of he resuls using he laen-variable mehodology wih he sandard mehodology shows ha he laer overesimaes he response of Treasury yields o moneary policy shocks. For he sample period June 6, 1989, hrough February 2, 2000, he sandard mehodology yields esimaes for bonds wih mauriies of 1 year or less ha are abou 40 o 50 percen oo large. For mauriies of 3 years and longer, he marginal response o moneary policy shocks is no saisically significan. For he February 3, June 29, 2007, period he marginal response o moneary policy 23

25 shocks is no saisically significan for any mauriy excep he 20-year Treasury yield, where he response is negaive. 24

26 References Balduzzi, P., E. Elon, and C. Green. (2001) Economic News and Bond Prices: Evidence from he U.S. Treasury Marke, Journal of Financial and Quaniaive Analysis, 36, Barolini, L., L. Goldberg, and A. Sacarny. (2008) How Economic News Moves Markes, Curren Issues in Economics and Finance, Federal Reserve Bank of New York, 14(6), 1-7. Belongia, M.T. and K.L. Kliesen. (1994) Effecs on Ineres Raes of Immediaely Releasing he FOMC Direcives, Conemporary Economic Policy, 12, Bernanke, B.S. and K.N. Kuner. (2005) Wha Explains he Sock Marke Reacion o Federal Reserve Policy? Journal of Finance, 60, Board of Governors of he Federal Reserve, Press Release, February 4, Board of Governors of he Federal Reserve, Press Release, July 6, Board of Governors of he Federal Reserve, Press Release, December 21, Board of Governors of he Federal Reserve, Press Release, February 2, Bomfim, A. (2003) Pre-Announcemen Effecs, News Effecs, and Volailiy: Moneary Policy and he Sock Marke, Journal of Banking and Finance, 27, Cochrane, J.H. and M. Piazzesi. (2002) The Fed and Ineres Raes: A High-Frequency Idenificaion, American Economic Review, 92, Cook, T. and T. Hahn. (1989) The Effec of Changes in he Federal Funds Rae Targe on Marke Ineres Raes in he 1970s, Journal of Moneary Economics, 24(3), Craine, R. and V.L. Marin. (2008) Inernaional Moneary Policy Surprise Spillovers, Journal of Inernaional Economics, 75, Faus, J., E.T. Swanson, and J.H. Wrigh. (2004) Indenifying VARs Based on High Frequency Fuures Daa, Journal of Moneary Economics, 51, Feinman, J.N. (1993) Esimaing he Open Marke Desk s Daily Reacion Funcion, Journal of Money, Credi and Banking, 25, Fleming, M.J. and E.M. Remolona. (1999) Price Formaion and Liquidiy in he U.S. Treasury Marke: The Response o Public Informaion, Journal of Finance, 54(5),

27 Gürkaynak, R.S., B.P. Sack, and E.T. Swanson. (2005) Do Acions Speak Louder Than Words? The Response of Asse Prices o Moneary Policy Acions and Saemens, Inernaional Journal of Cenral Banking, May, Gürkaynak, R.S., B.P. Sack, and E.T. Swanson. (2007) Marke-Based Measures of Moneary Policy Expecaions, Journal of Business and Economic Saisics, 25, Hamilon, J.D. (2008) Assessing Moneary Policy Effecs Using Daily Federal Funds Fuures Conracs, Federal Reserve Bank of S. Louis Review, 90(4), Kuner, K.N. (2001) Moneary Policy Surprises and Ineres Raes: Evidence from he Fed Funds Fuures Marke, Journal of Moneary Economics, 47(3), Piazzesi, M., and E.T. Swanson. (2008) Fuures Prices and Risk-Adjused Forecass of Moneary Policy, Journal of Moneary Economics, 55(4), Poole, W., R.H. Rasche. (2000) Perfecing he Marke s Knowledge of Moneary Policy, Journal of Financial Services Research, 18(2-3), Poole, W., R.H. Rasche, and D.L. Thornon. (2002) Marke Anicipaions of Moneary Policy Acions, Federal Reserve Bank of S. Louis Review, 84(4), Remolona, E.M. and M.J. Fleming. (1999) Wha Moves Bond Prices? Journal of Porfolio Managemen, 25(4), Rigobon, R., and B.P. Sack. (2004) The Impac of Moneary Policy on Asse Prices, Journal of Moneary Economics, 51, Rudebusch, G.D. (1998) Do Measures of Moneary Policy in a VAR Make Sense? Inernaional Economic Review, 39, Thornon, D.L. (2006a) When Did he FOMC Begin Targeing he Federal Funds Rae? Wha he Verbaim Transcrips Tell Us, Journal of Money, Credi and Banking, 38(8), Thornon, D.L. (2006b) Measured Pace in he Conduc of Moneary Policy, Federal Reserve Bank of S. Louis Moneary Trends, June Thornon, D.L. and D.C. Wheelock. (2000) A Hisory of he Asymmeric Policy Direcive, Federal Reserve Bank of S. Louis Review, 82(5), Wallich, H.C. (1984) Recen Techniques of Moneary Policy, Federal Reserve Bank of Kansas Ciy Economic Review,

28 Table 1: Correlaion of Kuner Shocks wih Changes in Treasury Raes (June 6, February 2, 2000) * u * u * u * u full sample ff 30 ff 15 ff 5 ff 2.5 b b No. of Obs Table 2: Response o Moneary Policy Shocks (June 6, February 2, 2000) p-value 1 p-value 2 p-value 2 R SE b b Table 3: Join-Response Bias Correced Responses o Moneary Policy Shocks (June 6, February 2, 2000) p-value p-value n p-value mps p-value 2 R SE b b

29 Table 4: Esimaes of Equaion (13) (June 6, February 2, 2000) n p-value h p-value mps p-value 2 R SE b b Table 5: Esimaes of Equaion (14) (June 6, February 2, 2000) n p-value lk p-value mps p-value 2 R SE b b

30 Table 6: Kuner Shocks on Days When he Targe Changed (February 3, June 29, 2007) Dae Kuner Shock Dae Kuner Shock 3/21/ /10/ /16/ /21/ /3/ /10/ /31/ /14/ /20/ /2/ /18/ /22/ /15/ /3/ /27/ /30/ /21/ /9/ /17/ /20/ /2/ /1/ /6/ /12/ /11/ /31/ /6/ /28/ /25/ /10/ /30/ /29/ Table 7: Response o Moneary Policy Shocks (February 3, June 29, 2007) p-value 1 p-value 2 p-value 2 R SE b b

31 Table 8: The Appropriaely Idenified Response o Moneary Policy Shocks (February 3, June 29, 2007) p-value p-value n p-value mps p-value 2 R SE b b

32 Jun Nov May 28 Nov May 17 Nov May Nov Apr Oc Apr Oc Apr Oc Mar Sep Mar Sep Mar Sep Mar Aug Feb Aug Feb Aug Jan Jul Jan Jul Jan Jul Jan Jun Dec Jun Dec Jun Figure 1: Difference Beween he Federal Funds Rae and he FOMC's Funds Rae Targe (June 6, June 29, 2007)

33 Jul Dec May Oc Mar Aug Jan Jun Nov Apr Sep Feb Jul Dec May Oc Mar Aug Jan Jun Nov Apr Sep Feb Jul Dec May Oc Mar Aug Jan Jun Nov Apr Sep Feb Jul Dec May Oc Mar Aug Jan Jun 0.25 Figure 2: The Monhly Average Absolue Difference of he Effecive Funds Rae from he Funds Rae Targe, July 1989-June

34 Figure 3: Densiies for June 6, February 2, 2000 and February 3, June 29, 2007 Sample Periods, Solid and Dashed Lines, Respecively T1 T10 33

35 Appendix A: Kuner Shocks Used Here and Kuner s Shocks for Kuner s Sample Period Dae Kuner shock Kuner s shock Dae Kuner shock Kuner s shock 6/6/ /20/ /7/ /9/ /27/ /2/ /16/ na 9/4/ /18/1989 na 0 2/4/ /6/ /22/ /20/ /18/ /13/ /17/ /29/ /16/ /14/ /15/ /7/ /1/ /18/1990 na /6/ /19/ na 12/19/ /8/1991 na /31/ /9/ na 3/25/ /1/ /29/ /8/ /16/ /30/ /17/ /6/ /30/ /13/ /24/ /31/ /16/ /6/ /2/ /6/

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