Jesse Torres' Fed School

Fed School: Federal Funds Rate Target Changes and the Financial Markets

 

In this edition of Fed School we go back to 1998 to break down a white paper written by Daniel L. Thornton, Vice President and Economic Advisor at the Federal Reserve Bank of St. Louis.

 

The white paper entitled "Tests of the Market's Reaction to Federal Funds Rate Target Changes," was published in the Federal Reserve Bank of St. Louis Review's November/December 1998 issue. Though this white paper is a decade old, the information contained within it is very relevant based upon the current tug-of-war between a weak economy and rising inflation. This review highlights and condenses Thornton's analysis without reference to the frightening calculus upon which Thornton bases his conclusions.

 

Federal Funds Target Rate and Monetary Policy

 

The Federal Funds Target Rate is of critical importance to the Federal Reserve because it is through the Federal Funds Target Rate that the Federal Reserve implements its monetary policy. While the Federal Reserve does not directly become involved in Federal Funds (Fed Funds) transactions, it plays a role through the use of repurchase agreements and reverse repurchase agreements purchased and sold by the Trading Desk at the Federal Reserve Bank of New York. The use of repos and reverse repos enables the Federal Reserve to effectively influence the Fed Funds rate. Thornton does not use this white paper to describe the mechanics behind the Trading Desk's manipulation of the Fed Funds Rate. Rather, Thornton focuses on the financial market's response to announced changes by the Federal Reserve to the Fed Funds Target Rate. John B. Taylor provides a good description of the manner in which Fed Funds rates are affected through the actions of the Trading Desk at the Federal Reserve Bank of New York in his white paper "Expectations, Open Market Operations, and Changes in the Federal Funds Rate."

 

It is generally accepted that a change by the Federal Reserve in the Federal Funds Target Rate is treated as a change in the Federal Reserve's monetary policy. While this comes as no surprise, what is fascinating about the Federal Funds Target Rate is that the financial markets respond not only to actual changes but also to expected or perceived changes - a concept referred to as Open Mouth Operations.

 

Federal Funds Target Rate and Inflation

 

It is widely believed that the Federal Reserve historically has been focusing its efforts on battling inflation and that it develops and implements its monetary policy in response to inflation scares. As such, it is commonly believed by economists, financial analysts and Federal Reserve watchers, that an increase in the Federal Funds Target Rate reflects an increased concern by the Federal Reserve about inflation. Further, many of these people believe that the size of the change in the Federal Funds Target Rate reflects the intensity of the Federal Reserve's concern over inflation.

 

Federal Funds Rate Changes Based on Target Rate Changes

 

If Thornton is correct in believing that the size of the Federal Funds Target Rate change is an indication of the Federal Reserve's concern (greater the change, greater the concern), then it naturally follows that the financial market's reactions would change in relation to the size of the change. Further, if the Federal Reserve changes the Discount Rate at the same time that it adjusts the Federal Funds Target Rate and the market believes the Discount Rate change reflects even greater concern, then the reaction by the financial markets should be larger than with only a Federal Funds Target Rate change.

 

Rather than making one bold change in time, the Federal Reserve generally makes an initial adjustment and then follows up with additional fine tuning rate adjustments in the same direction.

 

Interest Rate Changes - Real and Inflation Components

 

Regardless of their maturity, all interest rates have both a real and an inflation expectation component.

 

Interest Rate = Real Component + Inflation Expectation Component

 

Further, interest rates of all maturities respond to new information about real returns and future inflation. Therefore, and as noted above, news of actual changes to the Federal Funds Rate Target and/or Discount Rate by the Federal Open Market Committee (FOMC) or simply talk of expected changes (Open Mouth Operations) is likely to move rates. As Thornton describes, however, the real and inflation expectation components of interest rates move in opposite directions.

 

An increase in the Federal Funds Rate Target is expected to raise the real component of all rates. However, since rising rates also means the Federal Reserve has implemented a more restrictive monetary policy, the financial markets may also revise inflation expectations downward since a more restrictive monetary policy generally works to lower price inflation. As such, a rise in the Federal Funds Rate Target can cause nominal interest rates to rise or fall depending on the relative magnitude of each component (real rate component vs. inflation rate component).

 

For example, if the Federal Reserve increases or suggests that it will increase the Federal Funds Target Rate, the financial markets will determine the amount of change on the real rate and the inflation expectation component. If the real rate increase is greater than the rate decrease attributed to an expected decrease in inflation, in absolute terms, then the result is a net rate increase. If the same event results in a real rate component increase that is less than the rate decrease attributed to an expected decrease in inflation, in absolute terms, then the result is a net rate decrease.

 

Relative to this concept, Thornton states that the effect of a Federal Reserve monetary policy action intended to defeat inflation is not likely to be immediate and as such a revision of the inflation outlook is likely to have either a small or no effect on short-term rates. In other words, a rise in the Federal Funds Rate Target that is intended to raise interest rates for the purpose of beating down inflation will take time to affect inflation and will not happen overnight. As such, it is commonly accepted that short-term rates should move in the same direction as the Federal Funds Target Rate change, ignoring any change to the inflation expectation component.

 

Further, long-term rates may not respond significantly to Federal Funds Rate Target changes, even with no change to inflation expectations, due to long-term rates' reliance on the Expectation Theory of the Term Structure of Interest Rates.

 

Expectations Theory of the Term Structure of Interest Rates

 

The Expectations Theory of the Term Structure of Interest Rates states that the long-term rate is equal to the financial market's current expectation for short-term rates plus a constant risk premium. According to Thornton, if the Expectations Theory of the Term Structure of Interest Rates is true then a rise in the short-term rate that is expected to last for the term of the long-term bond or longer, will increase the long-term rate by the same amount.

 

If the Expectations Theory of the Term Structure of Interest Rates is true and if Federal Reserve policy actions have only a temporary effect on the real rate component, the effect of a target change on long-term rates will be smaller, the longer the term to maturity. In other words, if the financial market expects a real rate change to be only a temporary change then the effect of the rate change on long-term rates will be minimal to none.

 

If the Expectations Theory of the Term Structure of Interest Rates holds true then the fact that long-term rates respond little to changes in the Federal Funds Rate Target does not necessarily imply that the market has revised its expectation for inflation but instead it may indicate that the change in the real rate is expected to be temporary. Therefore, if the Federal Funds Rate Target is increased or is expected to increase, long-term rates may not change much for two reasons: 1) the real rate increase may be offset by the inflation expection decrease (rate change expected for the long-term) or 2) the real rate increase may be expected to last for only a short while, in which case long-term rates are minimally affected.

 

EXAMPLE:

 

• Federal Reserve raises Federal Funds Rate Target from 5.00% to 5.50%.
• Financial market expects Federal Reserve to drop rate back to 5.00% after 1 year.
• One year rate increases 50 basis points (1/2 percent) (full increase).
• 10 year rate increases 5 basis points (lesser increase because the financial market expects the rate to fall back down in one year).
• 30 year rate increases less than 2 basis points.

 

Based on this theory, it makes sense that short-term rates tend to respond significantly to changes in the Federal Funds Rate Target while long-term rate reactions are much smaller.

 

Segmented Markets Hypothesis

 

The Segmented Markets Hypothesis asserts that individuals have a preference to borrow or lend in one end of the market. Market participants do not shift from one end of the market to the other in response to changes in rate differentials. As such, the long-term rate is not necessarily equal to the average of the market's expectation for the short-term rate, even when the risk premium is zero.

 

Therefore, according to Thornton, if the Segmented Markets Hypothesis is valid, a shock at one end of the market is reflected in the other, but to different degrees. The relationship between long-term and short-term rates reflects the usual degree of arbitrage between these ends of the market. Or, it could reflect the differential response of both markets to the same shock - a change in the Federal Funds Rate Target.

 

The fact that the market responds differently to policy shocks suggests that they have different implications for those markets - an important difference is their implication for the future course of inflation.

 

Conclusion on White Paper

 

Thornton's "Tests of the Market's Reaction to Federal Funds Rate Target Changes" provides an insightful explanation on the effect that Federal Funds Rate Target changes have on the overall interest rate environment. But more specifically, the white paper addresses the reasons why the rates associated with certain maturities move significantly while others do not. Thornton provides a good explanation of the real rate and inflation expectation components and how those variables affect rate changes.

 

This Fed School article provides a summary of the Thornton's work. A reading of the white paper is recommended for further details, including the calculus behind Thornton's conclusions.