Using the Federal Funds Futures Market to Predict Monetary Policy Actions

Business Economics, April, 2001 by Raymond E. Owens, Roy H. Webb

Our paper reviews the roles of the Federal Funds Futures market in forecasting the federal funds rate. Statistical estimates are presented for the Federal Funds Futures markets efficiency at predicting FOMC policy actions. A key finding is that the market forecast contains useful information and is unbiased at the usual five percent level. That finding should be of interest to business economists, since it means that much of the costly information formerly acquired by specialized Fed watchers can now be obtained inexpensively by a non-specialist.

Changes in interest rates directly affect anyone who borrows or lends. A benchmark interest rate is the federal funds rate, the monetary policy instrument of the Federal Reserve System ("the Fed"). The federal funds rate serves as an anchor for the financial system, and other interest rates key off its current level and expected changes in it. Accurate predictions of changes in the federal funds rate are, therefore, of great value to persons engaged in a wide variety of business activities.

Forecasting interest rates during the last few decades has been especially difficult. Over that period, the economy has been rocked by a number of macroeconomic shocks that have had substantial impacts on interest rates. Equally difficult for analysts has been the challenge of accurately anticipating monetary policy actions in a setting in which the monetary policy process has been opaque. In recent decades, monetary policy goals have been numerous and on occasion contradictory, and policy has generally followed discretion rather than a set of clear, consistent rules. Clarity has also been limited by institutional practices that have provided incomplete information on monetary policy decisions to the public. Prior to 1994, for example, the Federal Open Market Committee (FOMC) used an operating procedure that targeted borrowed reserves and yielded a federal funds rate objective that was difficult to elucidate even well after the fact (Cook, 1989). In addition, during that period the FOMC chose not to immediately reveal its policy decision or its inclination regarding near-term future policy actions at the conclusion of its meetings, leaving financial market participants to guess the action taken.

Beyond these factors, at least until October 1988, the specific sources of changes in short-term interest rate forecasts also were often difficult to identify because financial market forecasters often relied on the yields on short-term Treasury securities as their benchmark for short-term interest rates. Although changes in these rates were often affected by anticipated Fed policy actions, interest rate movements were also affected by changes in expected inflation, Treasury refunding plans, and other variables. These factors could lead to a highly variable spread between rates on short Treasuries and those on federal funds. As a result, a change in interest rates could arise from sources other than monetary policy actions, and no independent means was usually available to decompose the change into the impacts from the individual factors. This situation changed to some extent in 1988 when the Chicago Board of Trade (CBOT) began trading 30-day Federal Funds Futures, a contract based on the average monthly federal funds interest rate, the Fed's monetary policy instrument. This contract has been widely interpreted as an unbiased forecast of the expected interest rate on federal funds and has been considered a useful tool in identifying the impact of anticipated changes in monetary policy on interest rates. Of course, this estimate does not necessarily move in lockstep with expected movements in interest rates on other short-term securities, because of the other factors often embedded in those rates.

In this article, we review the development and basic mechanics of the Federal Funds Futures market. Following this description, we show that efforts to assess the usefulness of this market as a predictor of subsequent Fed monetary policy actions have generally supported the value of this tool. Our new look at the market emphasizes that the federal funds futures market provides a valuable forecasting tool to the public at a nearly zero cost-namely an unbiased, reasonably accurate forecast of the future federal funds rate changes by the FOMC.

The Federal Funds Futures Market

Federal Funds Futures contracts began trading on the floor of the Chicago Board of Trade in October 1988. This event signaled the beginning of essentially public, market-based forecasts of future interest rates on federal funds. The traditional price-discovery mechanism of futures markets thus began to provide outside observers with the basic knowledge needed to construct informed forecasts of FOMC target changes. There are several steps involved in processing the market quotes, however, and at this point it will be helpful to review the specifics of the contract.

The contract traded is, of course, a well-defined instrument, and identifying changes in the federal funds rate embedded in the contract prices requires some simple arithmetic. First, though, are the basics of the con tract. Federal Funds Futures contracts are traded for the current month and for future months--effectively about six or seven months out. The contracts are for the interest paid on a principal amount of $5 million of overnight federal funds held for thirty days and are priced on the basis of 100 minus the average overnight federal funds rate for the delivery month. A 7.25 yield, for example, equals a price of 100 minus 7.25, or 92.75. For settlement purposes, the contract is to be compared to the average daily federal funds effective rate as reported by the Federal Reserve Bank of New York.