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October 18, 2021
Market Response to Taper Talk
As the Fed discusses reducing its $120 billion in monthly purchases of Treasury and mortgage-backed securities, market pundits have begun to form opinions on whether such talk about tapering will roil markets as it did in 2013. Some believe that, given the size of the Fed's monthly purchases, such discussion will lead to similar market reactions. Others believe that markets today better understand the Fed's decision-making process around its asset purchases and interest rate policy. This market knowledge and experience may help mitigate the negative effect taper talk could have this time. In this post, we provide evidence that both perspectives are at least partially correct.
To be specific, we analyze the past and present discussions on tapering, including the effects that the Federal Open Market Committee's (FOMC) September 2013 meeting, often referred to as the "untaper" meeting because plans for tapering were delayed, and the June 2021 "talking about talking about tapering" meeting had on the market's expectations for the future path of the fed funds rate. We show that a market response similar to 2013 has already occurred in the sense that an increase in the 10-year Treasury rate coincided with market participants expecting an earlier liftoff from a fed funds rate of zero. Subsequent taper talk only marginally affected how the market expects the pace of rate hikes to proceed. In other words, the market responds to increasing Treasury rates by first pricing in a strong opinion about how much time will pass before the first rate hike. Subsequent discussions about tapering have little to no effect on the market expectations for future interest rate policy.
For our analysis, we use the Federal Reserve Bank of Atlanta's, Market Probability Tracker (MPT), to measure the market's expectations for the future course of monetary policy. The MPT is computed and reported every day on the Federal Reserve Bank of Atlanta's website and is described in detail in an Atlanta Fed "Notes from the Vault" post. The MPT uses options contracts on Eurodollar futures to estimate the market's assessment of the target ranges of future effective fed funds rate. Using derivative contracts on Eurodollars has one main advantage over studying the effective fed fund futures directly. Unlike the futures market for fed funds, the options on Eurodollar futures market is one of the most liquid in the world, with a wide collection of traded options. Moreover, Eurodollar futures deliver three-month LIBOR (or London Interbank Offered Rate), which bears a stable relation and high correlation with the effective fed funds rate in global overnight money markets. Together, these features allow the MPT to extract more confidently measures of market expectations of future effective fed funds target ranges.
Turning our attention first to 2013, we look at how the market's expectations for the future path of rates changed as taper talk began to heat up. In figure 1, we plot several of the MPT's daily expected fed funds rate paths from before and after June 2013. Each unlabeled path in the figure is represented by a transparent blue line of the market expectations for the fed funds rate path as of Wednesday of that week. These weekly expected rate paths began on May 1, 2013, and ended on December 18, 2013, when the Fed announced it would begin paring down its asset purchases.
Note: Expectations computed daily with option data on Eurodollar futures contracts from May 1, 2013, to December 18, 2013. Each unlabeled line represents the market's expected path for monetary policy given the data as of Wednesday of the indicated week.
The orange line in figure 1 represents the market expectations as of May 1, 2013. At that time, no substantive discussion about the Fed shrinking its asset purchases had taken place. The FOMC had just released a statement that it would continue to purchase assets "until the outlook for the labor market has improved substantially in a context of price stability." Regarding its interest rate policy, the Committee stated that it "expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens." Given the Fed's policy, along with the state of the economy, the market expected the first rate hike to be in mid- to late 2015.
Between May 2013 and the next FOMC meeting on June 19, 2013 (the dashed blue line in figure 1), the market's expectation for future monetary policy began to price in an earlier rate hike sometime between late 2014 to early 2015 (see the sequence of transparent blue lines in figure 1 that move up and to the left from the orange to the dashed blue line). During this period between FOMC meetings, Ben Bernanke, then chairman of the Board of Governors, testified to Congress that the FOMC "could in the next few meetings...take a step down in our pace of purchases" (Bernanke Q&A congressional testimony, May 22, 2013).
Bernanke's May 2013 testimony may have contributed to pulling forward market expectations for when the Fed would end its highly accommodative monetary policy since many expected the Fed's asset purchases to end before the fed funds rate was increased from its zero lower bound. The chair's testimony is also credited with setting off what is commonly referred to as the "taper tantrum" in the Treasury market. In figure 2, the blue line shows how much the 10-year Treasury rate had changed since May 1, 2013. According to this figure, Bernanke's testimony was certainly followed by an increase in the 10-year Treasury rate, but this increase continued a trend that began back in May 2013. And market participants had been pricing in an earlier and earlier liftoff date while the 10-year rate was increasing in May, not when the chair testified to Congress.
Note: The blue line represents the change from May 1, 2013, to February 24, 2015. The orange line represents the change from November 5, 2020, to August 27, 2021.
The Committee's June 2013 statement on monetary policy changed little from its May statement, but the expected path for the fed funds rate had already steepened (compare the dashed blue line with the orange line in figure 1). Notably, it was over the six days that followed the June FOMC statement that the 10-year Treasury increased by 40 basis points (see the blue line in figure 2). Many believe this increase in the 10-year rate was due to Bernanke's comments during the post-FOMC press conference when, in responding to a question about asset purchases, he said it would be appropriate to moderate purchases "later this year" and to end purchases "around midyear" 2014. However, for our purposes, we point out the muted impact Bernanke's answer had on the expected rate paths plotted in figure 1.
Over the next couple of months, changes in the fed funds rate path continued to be minimal even in response to Bernanke's attempt to calm other markets by assuring market participants the Fed was committed to a highly accommodative monetary policy. By the September FOMC meeting—a meeting sometimes referred to as the "untapering" meeting because the Committee decided to "await more evidence that progress will be sustained before adjusting the pace of its purchases"—the expected funds rate path was statistically indistinguishable from the June rate path (see the dashed black line in figure 1). However, the September announcement to delay the tapering of its purchases appeared to have caught bond investors by surprise. In figure 2, we see that the 10-year Treasury rate (the blue line) dropped by approximately 20 basis points over the coming weeks—all while the market's expectation for the timing of liftoff remained relatively constant.
Over the rest of 2013, the pace of the expected rate hikes stayed relatively stable. Figure 1 shows this stability by the similar curvature of the expected path lines from September to December. Interestingly, the December FOMC formal announcement that the Fed would begin to reduce its monthly purchases of Treasuries and mortgage-backed securities (MBS) by $5 billion each did not change the market's expectations for how long it would be before liftoff (see the solid black line in figure 1). We interpret this as market participants having formed their expectations about the future pace of interest rate hikes when the Treasury rates had increased and as policymakers were beginning to talk about tapering and not when the Fed announced the actual date and pace of its shrinkage in asset purchases.
Now compare figure 1 to the sequence of expected rate paths plotted in figure 3 for the time interval of November 5, 2020, to August 11, 2021. Early in this time period, the orange line in figure 2 shows the 10-year Treasury rate increasing 95 basis points from November 2020 to the end of March 2021 (the high point of the orange line in figure 2). This increase in the 10-year rate was due in part to the improving economic conditions and optimism around the advent of COVID-19 vaccines. This time period also corresponds with a steepening in the market expectations for the fed funds rate path seen in figure 3. The "lower for longer" policy of the Fed can be seen in the flat November FOMC rate path (compare the orange rate paths in figures 1 and 3). But as in figure 1, the expected rate paths in figure 3 gradually steepen while the 10-year rate is increasing.
Note: The fed funds rate path was computed from daily option data on Eurodollar futures contracts from November 5, 2020, to August 27, 2021. Each unlabeled line represents the market's expected path for monetary policy given the data as of Wednesday of the week
The minutes from the April FOMC were released to the public on May 19, 2021 (see the pink rate path in figure 3). These minutes describe several participants suggesting that "it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases." Discussion about shrinking the monthly purchases of assets continued into the June 2021 FOMC meeting. Importantly, at the June FOMC press conference, Fed chair Jerome Powell responded to a question about the timeline for reducing asset purchases by saying that people can think of the June meeting as the "talking about talking about" meeting.
The market's expectation about the fed funds rate path to this taper chatter was muted. Market expectations for the first rate hike had already moved up from the middle of 2024 to the first half of 2023. Given the similarity in the paths at the FOMC meetings in June (see the dotted black line in figure 3) and July (the dashed black line in figure 3), and after Chair Powell's Jackson Hole speech (the solid black line), market participants did not alter their expectations about liftoff. Not even the June FOMC's hawkish Summary of Economic Projections affected the views of market participants on the future course of interest rates.
Comparing the sequence of 2013 and 2020–21 rate paths plotted in figures 1 and 3, we might believe that those who think tapering in 2021 will lead to a similar market reaction as in 2013 are right—but only in the sense that both events corresponded to a sizeable increase in the 10-year Treasury rate and not the actual taper.
That being said, after the rate paths in figures 1 and 3 steepened, the limited impact that taper talk had on the rate paths lends support to those who expect tapering to be a nonevent. The relatively constant pace of expected rate hikes found in 2013 and 2021 suggests that a formal announcement by the Fed on reducing its purchases of Treasuries and agency MBS will likely have a limited effect on the market expectations for the pace of future rate hikes. This is especially true for the 18- to 24-month time horizon of the rate paths.
Regardless of whether we believe that there will or will not be a "taper tantrum" similar to the one in 2013, the market expectations calculated from the Eurodollar futures market clearly show two common effects from the events of 2013 and 2020–21. The first is that as the 10-year Treasury rate begins to rise, market participants expect the Fed to start raising the fed funds rate earlier than before. The second effect is that after the first effect, the expected pace of future rate hikes does not appear to be very responsive to taper talk. Hopefully, knowledge of these tapering-related empirical regularities will help market participants form more accurate predictions about future interest rate policies.
November 20, 2013
The Shadow Knows (the Fed Funds Rate)
The fed funds rate has been at the zero lower bound (ZLB) since the end of 2008. To provide a further boost to the economy, the Federal Open Market Committee (FOMC) has embarked on unconventional forms of monetary policy (a mix of forward guidance and large-scale asset purchases). This situation has created a bit of an issue for economic forecasters, who use models that attempt to summarize historical patterns and relationships.
The fed funds rate, which usually varies with economic conditions, has now been stuck at near zero for 20 quarters, damping its historical correlation with economic variables like real gross domestic product (GDP), the unemployment rate, and inflation. As a result, forecasts that stem from these models may not be useful or meaningful even after policy has normalized.
A related issue for forecasters of the ZLB period is how to characterize unconventional monetary policy in a meaningful way inside their models. Attempts to summarize current policy have led some forecasters to create a "virtual" fed funds rate, as originally proposed by Chung et al. and incorporated by us in this macroblog post. This approach uses a conversion factor to translate changes in the Fed's balance sheet into fed funds rate equivalents. However, it admits no role for forward guidance, which is one of the primary tools the FOMC is currently using.
So what's a forecaster to do? Thankfully, Jim Hamilton over at Econbrowser has pointed to a potential patch. However, this solution carries with it a nefarious-sounding moniker—the shadow rate—which calls to mind a treacherous journey deep within the hinterlands of financial economics, fraught with pitfalls and danger.
The shadow rate can be negative at the ZLB; it is estimated using Treasury forward rates out to a 10-year horizon. Fortunately we don't need to take a jaunt into the hinterlands, because the paper's authors, Cynthia Wu and Dora Xia, have made their shadow rate publicly available. In fact, they write that all researchers have to do is "...update their favorite [statistical model] using the shadow rate for the ZLB period."
That's just what we did. We took five of our favorite models (Bayesian vector autoregressions, or BVARs) and spliced in the shadow rate starting in 1Q 2009. The shadow rate is currently hovering around minus 2 percent, suggesting a more accommodative environment than what the effective fed funds rate (stuck around 15 basis points) can deliver. Given the extra policy accommodation, we'd expect to see a bit more growth and a lower unemployment rate when using the shadow rate.
Before showing the average forecasts that come out of our models, we want to point out a few things. First, these are merely statistical forecasts and not the forecast that our boss brings with him to FOMC meetings. Second, there are alternative shadow rates out there. In fact, St. Louis Fed President James Bullard mentioned another one about a year ago based on work by Leo Krippner. At the time, that shadow rate was around minus 5 percent, much further below Wu and Xia's shadow rate (which was around minus 1.2 percent at the end of last year). Considering the disagreement between the two rates, we might want to take these forecasts with a grain of salt.
Caveats aside, we get a somewhat stronger path for real GDP growth and a lower unemployment rate path, consistent with what we'd expect additional stimulus to do. However, our core personal consumption expenditures inflation forecast seems to still be suffering from the dreaded price-puzzle. (We Googled it for you.)
Perhaps more important, the fed funds projections that emerge from this model appear to be much more believable. Rather than calling for an immediate liftoff, as the standard approach does, the average forecast of the shadow rate doesn't turn positive until the second half of 2015. This is similar to the most recent Wall Street Journal poll of economic forecasters, and the September New York Fed survey of primary dealers. The median respondent to that survey expects the first fed funds increase to occur in the third quarter of 2015. The shadow rate forecast has the added benefit of not being at odds with the current threshold-based guidance discussed in today's release of the minutes from the FOMC's October meeting.
Moreover, today's FOMC minutes stated, "modifications to the forward guidance for the federal funds rate could be implemented in the future, either to improve clarity or to add to policy accommodation, perhaps in conjunction with a reduction in the pace of asset purchases as part of a rebalancing of the Committee's tools." In this event, the shadow rate might be a useful scorecard for measuring the total effect of these policy actions.
It seems that if you want to summarize the stance of policy right now, just maybe...the shadow knows.
By Pat Higgins, senior economist, and
Brent Meyer, research economist, both of the Atlanta Fed's research department
August 19, 2013
Does Forward Guidance Reach Main Street?
The Federal Open Market Committee (FOMC) has been operating with two tools (well described in a recent speech by our boss here in Atlanta). The first is our large-scale asset purchase program, or QE to everyone outside of the Federal Reserve. The second is our forward guidance on the federal funds rate. Here’s what the fed funds guidance was following the July FOMC meeting:
[T]he Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.
The quarterly projections of the June FOMC meeting participants give more specific guidance on the fed funds rate assuming “appropriate” monetary policy. All but one FOMC participant expects the funds rate to be lifted off the floor in 2015, with the median projection that the fed funds rate will be 1 percent by the end of 2015.
But forward guidance isn’t worth much if the public has a very different view of how long the fed funds rate will be held near zero. The Federal Reserve Bank of New York has a good read on Wall Street’s expectation for the federal funds rate. Its June survey of primary dealers (a set of institutions the Fed trades with when conducting open market operations) saw a 52 percent chance that the fed funds rate will rise from zero in 2015, and the median forecast of the group saw the fed funds rate at 0.75 percent at the end of 2015. In other words, the bond market is broadly in agreement with the fed funds rate projections made by FOMC meeting participants.
But what do we know about Main Street’s perspective on the fed funds rate? Do they even have an opinion on the subject?
Our perspective on Main Street comes from our panel of businesses who participate in the monthly Business Inflation Expectations (BIE) Survey. And we used our special question to the panel this month to see if we could gauge how, indeed whether, businesses have opinions about the future of the federal funds rate. Here’s the specific question we put to the group:
Currently the fed funds rate is near 0%. [In June, the Federal Reserve projected the federal funds rate to be 1% by the end of 2015.] Please assign a percentage likelihood to the following possible ranges for the federal funds rate at the end of 2015 (values should sum to 100%).
In the chart below, we plot the distribution of panelists’ median-probability forecast (the green bars) compared to the distribution of the FOMC’s June projection (we’ve simply smushed the FOMC’s dots into the appropriately categorized blue bars).
Seventy-five percent of our respondents had a median-probability forecast for the fed funds rate somewhere between 0.5 percent and 1.5 percent by the end of 2015. That forecast compares very closely to the 73 percent of the June FOMC meeting participants.
You may have noticed in the above question a bracketed bit of information about the Federal Reserve’s forecast for the federal funds rate: “In June, the Federal Reserve projected the federal funds rate to be 1% by the end of 2015.” Actually, this bit of extra information was supplied only to half of our panel (selected at random). A comparison between these two panel subsets is shown in the chart below.
These two subsets are very similar. (If you squint, you might see that the green bars appear a little more diffuse, but this isn’t a statistically significant difference…we checked.) This result suggests that the extra bit of information we provided was largely extraneous. Our business panel seems to have already had enough information on which to make an informed prediction about the federal funds rate.
Finally, the data shown in the two figures above are for those panelists who opted to answer the question we posed. But, at our instruction, not every firm chose to make a prediction for the federal funds rate. With this month’s special question, we instructed our panelists to “Please feel free to leave this question blank if you have no opinion.” A significant number of our panelists exercised this option.
The typical nonresponse rate from the BIE survey special question is about 2 percent. This month, it was 22 percent—which suggests that an unusually high share of our panel had no opinion on the future of the fed funds rate. What does this mean? Well, it could mean that a significant share of Main Street businesses are confused by the FOMC’s communications and are therefore unable to form an opinion. But a high nonresponse rate could also mean that some segment of Main Street businesses don’t believe that forward guidance on the fed funds rate affects their businesses much.
Unfortunately, the data we have don’t put us in a very good position to distinguish between confusion and apathy. Besides, we’re optimistic sorts. We’re going to emphasize that 78 percent of those businesses we surveyed responded to the question, and that typical response lined up pretty well with the opinions of FOMC meeting participants and the expectations of Wall Street. So, while not everyone is dialed in to our forward guidance, Main Street seems to get it.
By Mike Bryan, vice president and senior economist,
Brent Meyer, economist, and
Nicholas Parker, senior economic research analyst, all in the Atlanta Fed's research department
March 8, 2013
Will the Next Exit from Monetary Stimulus Really Be Different from the Last?
Suppose you run a manufacturing business—let's say, for example, widgets. Your customers are loyal and steady, but you are never completely certain when they are going to show up asking you to satisfy their widget desires.
Given this uncertainty, you consider two different strategies to meet the needs of your customers. One option is to produce a large quantity of widgets at once, store the product in your warehouse, and when a customer calls, pull the widgets out of inventory as required.
A second option is to simply wait until buyers arrive at your door and produce widgets on demand, which you can do instantaneously and in as large a quantity as you like.
Thinking only about whether you can meet customer demand when it presents itself, these two options are basically identical. In the first case you have a large inventory to support your sales. In the second case you have a large—in fact, infinitely large—"shadow" inventory that you can bring into existence in lockstep with demand.
I invite you to think about this example as you contemplate this familiar graph of the Federal Reserve's balance sheet:
I gather that a good measure of concern about the size of the Fed's (still growing) balance sheet comes from the notion that there is more inherent inflation risk with bank reserves that exceed $1.5 trillion than there would be with reserves somewhere in the neighborhood of $10 billion (which would be the ballpark value for the pre-crisis level of reserves).
I understand this concern, but I don't believe that it is entirely warranted. My argument is as follows: The policy strategy for tightening policy (or exiting stimulus) when the banking system is flush with reserves is equivalent to the strategy when the banking system has low (or even zero) reserves in the same way that the two strategies for meeting customer demand that I offered at the outset of this post are equivalent.
Here's why. Suppose, just for example, that bank reserves are literally zero and the Federal Open Market Committee (FOMC) has set a federal funds rate target of, say, 3 percent. Despite the fact that bank reserves are zero there is a real sense in which the potential size of the balance sheet—the shadow balance sheet, if you will—is very large.
The reason is that when the FOMC sets a target for the federal funds rate, it is sending very specific instructions to the folks from the Open Market Desk at the New York Fed, who run monetary policy operations on behalf of the FOMC. Those instructions are really pretty simple: If you have to inject more bank reserves (and hence expand the size of the Fed's balance sheet) to maintain the FOMC's funds rate target, do it.
To make sense of that statement, it is helpful to remember that the federal funds rate is an overnight interest rate that is determined by the supply and demand for bank reserves. Simplifying just a bit, the demand for reserves comes from the banking system, and the supply comes from the Fed. As in any supply and demand story, if demand goes up, so does the "price"—in this case, the federal funds rate.
In our hypothetical example, the Open Market Desk has been instructed not to let the federal funds rate deviate from 3 percent—at least not for very long. With such instructions, there is really only one thing to do in the case that demand from the banking system increases—create more reserves.
To put it in the terms of the business example I started out with, in setting a funds rate target the FOMC is giving the Open Market Desk the following marching orders: If customers show up, step up the production and meet the demand. The Fed's balance sheet in this case will automatically expand to meet bank reserve demand, just as the businessperson's inventory would expand to support the demand for widgets. As with the businessperson in my example, there is little difference between holding a large tangible inventory and standing ready to supply on demand from a shadow inventory.
Though the analogy is not completely perfect—in the case of the Fed's balance sheet, for example it is the banks and not the business (i.e., the Fed) that hold the inventory—I think the story provides an intuitive way to process the following comments (courtesy of Bloomberg) from Fed Chairman Ben Bernanke, from last week's congressional testimony:
"Raising interest rate on reserves" when the balance sheet is large is the functional equivalent to raising the federal funds rate when the actual balance sheet is not so large, but the potential or shadow balance sheet is. In both cases, the strategy is to induce banks to resist deploying available reserves to expand deposit liabilities and credit. The only difference is that, in the former case, the available reserves are explicit, and in the latter case they are implicit.
The Monetary Policy Report that accompanied the Chairman's testimony contained a fairly thorough summary of costs that might be associated with continued monetary stimulus. Some of these in fact pertain to the size of the Fed's balance sheet. But, as the Chairman notes in the video clip above, when it comes to the mechanics of exiting from policy stimulus, the real challenge is the familiar one of knowing when it is time to alter course.
By Dave Altig, executive vice president and research director of the Atlanta Fed
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