Connecting the dots: Market reactions to forecasts of policy rates and forward guidance provided by the Fed

Abstract

This paper compares market reactions to forecasts of the policy rate path provided by FOMC participants ("dots") in the Summary of Economic Projections (SEP) with those to forward guidance provided by the FOMC in its statements. We find that market expectations of the time to lift-off from the zero lower bound are significantly affected in the expected direction by surprises in SEP dots and in forward guidance. We also find a significant impact of macroeconomic news on market participants' expectations of time to lift-off. These results are consistent with forward guidance about policy rates and SEP forecasts each contributing to the public's understanding of future Federal Reserve monetary policy, and with the conditionality of both forms of communication about future policy rates being understood. We also present evidence that market expectations concerning the time to lift-off are influenced by the maximum time to lift-off implied by forward guidance, the SEP and the economic outlook. An appendix provides the FOMC's forward guidance after each meeting from January 2012 to September 2015 and our interpretation of the implied days to liftoff.

Effects of Fed policy rate forecasts on real yields and inflation expectations at the zero lower bound

“…, for horizons m = 2-10 years ahead, and 5 years 5 years ahead (m=5y/5y), to surprises in SEP policy rate forecast, t sur , based on Bongard et al (2020),…”

“…where −1 is the market's expectation of the SEP forecast on the day prior to its publication. As a proxy for the market expectation of the SEP's forecast, −1 , we use the following expected time to lift-off on the day prior to publication of the SEP forecast (as in Bongard et al, 2020),…”

“…As a robustness test, we also include a second proxy measure for market expectations of SEP forecasts, which is a weighted average of the measure of equation ( 2), and the time to lift off implied by the previously made SEP forecast on the day prior to publication of the new forecast, −1 (as in Bongard et al, 2020)…”

“…We use estimates of the Fed's expected days to lift-off from the ZLB from the SEP forecasts, SEPDAYS, defined as the time until the date at which the median expectation across the different forecasts has reached 37.5 basis points (not restricted to occur on FOMC meeting dates), from Bongard et al (2020). These use linear interpolation between the yearly forecasted median expectations in order to estimate the dates when lift-off will occur based on the SEP forecasts.…”

“…To construct the surprise in the Fed's expected days to lift-off from the ZLB on the dates of the publication of the SEP forecasts, we also use the following measure of market participants' expectations of the time to Fed lift-off as in Bongard et al (2020). It is derived from data on a range of fed funds futures contracts from Bloomberg.…”