Yesterday night, Cleveland Fed published a short report analysing the effect of shifting expectations for future monetary policy on current interest rates. It underlined that by changing their views about future economic conditions and the likely policy response, monetary policymakers can alter financial conditions in the present. As a consequence, without acting directly, policymakers could reveal their expectations and influence the effectiveness of their policies.
More from Cleveland Fed:
One of the likely causes of the strong reaction of financial markets to the June meeting was the release of the Committee’s economic projections. Those projections reflected some improvement in the FOMC’s forecast, notably for the unemployment rate, over the Committee’s previously released projections in March.
Looking at these yields on the date of the June meeting provides further evidence of the impact that the FOMC’s outlook is having on financial conditions. Sharp increases are observed in the intraday yields for the 2-year treasury rate, which coincide with the release of new economic projections and the Chairman’s press conference on future plans for monetary policy.
Additionally, expectations about the projected path of short-term interest rates play a major role in determining the current level of long-term interest rates, so this shift in expectations is likely to feed through to current interest rates on securities with longer maturities, like 2- or 10-year Treasury bonds, as well as mortgages or auto loans.
Another potential cause of the recent shift in interest rates, especially on longer-term securities, is changes to expectations about the Federal Reserve’s asset purchase program. The Federal Reserve started purchasing long-term securities when the primary monetary policy tool, the target federal funds rate, reached its zero lower bound following the financial crisis, and further easing in financial conditions was needed. Since this program is a tool meant to influence interest rates, changes in how these purchases are expected to evolve are likely to impact the behavior of interest rates as well. At the June meeting, Chairman Bernanke laid out a potential path of asset purchases if the economic recovery were to proceed as forecasted. The Chairman’s statement may have caused the market’s expectations about the path of asset purchases to shift from previous projections closer to the path he presented, which would impact the current level of interest rates.
One view of potential shifts in expectations for asset purchases is drawn from the Survey of Primary Dealers. Primary dealers—financial institutions that trade securities directly with the Federal Reserve—are regularly surveyed on their expectations for the economy, monetary policy, and financial market developments prior to FOMC meetings. Data from this survey show that there was a downward shift to the expected pace of asset purchases following the June meeting. This shift is likely playing some role in the recent increases in interest rates, although it is tough to determine what the impact is or to differentiate it from the impact of shifts in the expectations of other policy tools.
Even as monetary policy actions remain consistent, expectations about future monetary policy actions are likely to change as the economy evolves. As these expectations change, they are likely to have a fresh impact on current financial and economic conditions.