PDF Ebook A Model for the Federal Funds Rate Target
This paper is a statistical analysis of the manner in which the Federal Reserve deterM mines the level of the federal funds rate target, one of the most publicized and anticipated economic indicators in the financial world. The paper introduces new statistical tools for forecasting a discreteMvalued time series such as the target, and suggests that these methods, in conjunction with a focus on the institutional details of how the target is determined, can significantly improve on standard VAR forecasts of the effective federal funds rate. We further show that the news that the Fed has changed the target has substantially different statistical content from the news that the Fed failed to make an anticipated target change, causing us to challenge some of the conclusions drawn from standard linear VAR impulseM response functions.
This paper is a statistical analysis of the manner in which the Federal Reserve System (the Fed) determines the level of shortMterm interest rates in the U.S. In particular, we study when and how the Fed decides to change the level of the federal funds rate target, one of the most publicized and anticipated indicators for financial markets all over the world. The target (for short) is an internal objective that is set by the Chairman of the Federal Reserve System in compliance with the directives agreed upon at the Federal Open Market Committee (FOMC) meetings. The target is used by the Trading Desk of the Federal Reserve Bank of New York as a guide for the daily conduct of open market operations. We believe the target is of considerable economic interest precisely because it is not the outcome of the interaction of supply and demand of federal funds and it is not subject to technical fluctuations or extraneous sources of noise. Rather, it is an operational indicator of how the direction of monetary policy determined by the FOMC is translated into practice.
This paper introduces new statistical tools for forecasting a discrete valued time series such as the target, and suggests that one can substantially improve on standard VAR foreM casts of the effective federal funds rate by focusing on these aspects of the data along with institutional details of how the target gets set. We illustrate how our framework can be used as an alternative to the usual VAR impulse response analysis to measure the effects of monetary policy. In a standard recursively identified VAR, a monetary policy shock is measured as the difference between the federal funds rate and the rate that one would have predicted using the lagged and specified contemporaneous variables in the VAR. Such a linear representation makes no distinction between a forecast error that arises because the Fed unexpectedly raised the target and one where a drop in the target was anticipated but failed to materialize. In our nonlinear forecasting model, by contrast, the two events turn out to contain quite different statistical information. If the Fed unexpectedly raises the target, it would cause one to revise a forecast of future employment substantially downward. A 25MbasisMpoint target hike would lead one to predict a 0.2 percent decrease in employment a year later, twice as large a drop as implied by a linear VAR. On the other hand, if one expected the Fed to lower the target 25 basis points and it did not, the new information should cause little change in the predicted level of employment. The rational expectation is that the Fed will go ahead and lower the target at the next FOMC meeting with the same implications for employment a year out. We argue that the usual linear VAR is actually measuring a combination of these two very different events.
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PDF Ebook A Model for the Federal Funds Rate Target
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