Expectations and the Monetary Policy Transmission Mechanism

Federal Reserve Bank of Kansas City - Economic Review, Fourth Quarter 2004 by Sellon, Gordon H Jr

The principal message of this example is that the response of market rates to changes in the policy path also depends on the size of expected changes in future funds rate targets. If markets sometimes build single target changes and sometimes build multiple target changes into a revised policy path, the response of markets rates may differ greatly in the two situations. This factor may also help explain some of the variability in the relationship between the funds rate target and the ten-year rate shown in Chart 3.

IV. A CLOSER LOOK AT THE POLICY PATH

Because central banks do not generally provide detailed information about future policy actions, financial market participants must develop their own estimate of the policy path based on their understanding of central bank behavior and a forecast of the economic outlook. The market's estimate of the policy path can then be derived from information on market interest rates and can be used to provide valuable insight into the relationship between monetary policy and market interest rates.

Obtaining an estimate of the policy path from market interest rates

In recent years, the Federal Reserve and many other central banks have greatly increased the amount of monetary policy information released to the public. For example, the FOMC now announces policy decisions on the day of its meetings and provides additional information about the rationale for its decisions, its views on the balance of risks to the economic outlook, and the votes of committee members.10 However, like most other central banks, the Federal Reserve does not provide detailed information about the future policy path beyond today's federal funds rate target.11

Whether central banks should provide a more detailed policy path has been the subject of an ongoing debate among academic economists and central bank policymakers. Some economists have suggested that monetary policy would be more effective if central banks were to publish their economic forecasts and to specify the future path for their interest rate target. In response, central bank policymakers have emphasized the conceptual and practical difficulties in determining the path and have also questioned the usefulness of providing this information to financial markets.12

Without going into the details of this debate, it is important to recognize that a policy path must exist even if it is not provided by the central bank.13 As discussed in the previous section, a path is implicit in market interest rates. Consequently, even if central banks do not specify a policy path, it should be possible to extract the financial markets' estimate of the policy path from data on market interest rates.

Indeed, economists have devised a number of methods for deriving estimates of the policy path from financial markets.14 One of the more popular approaches is to use data on financial futures. For example, the federal funds futures market provides a direct estimate of the federal funds rate that investors expect several months ahead. By combining information on federal funds rate futures and eurodollar futures, it is possible to estimate the federal funds rate targets expected by financial markets over a period out to five years ahead (Sack).