Interest Rates Have Responded to the Fed's New Language

Article excerpt

At its August policy meeting, the Federal Reserve took the unprecedented step of establishing a specific future date for policy action given current economic conditions. The intention was to clearly communicate to the public that, in light of what is currently known about the economic outlook, the Federal Reserve expects to keep interest rates extremely low for longer than the public previously believed. A quick look at some of the market reaction to the August Federal Open Market Committee (FOMC) statement shows that the change in statement language was successful in altering public expectations of future interest rates and, in turn, current interest rates.

This was a unique move in the realm of FOMC policy changes, partly because it was only operational through the language in the Committee's statement, and partly because of the reference to a specific date. The FOMC made a similar move when it added the "extended period" language in March 2009. By making a tentative commitment to not raise interest rates until the middle of 2013, the Committee was attempting to alter the expectations of market participants. It worked. Since the announcement, forecasts for a variety of interest rates have fallen, at least in part due to the lower expectations for future interest rates.

Despite the emphasis on expectations, this shift out in time for raising short-term interest rates has also had influences on current interest rates. The yields on Treasury securities maturing within one year were already at extremely low rates, but yields on maturities of 2 years or longer have fallen noticeably since the announcement. The 2-year Treasury rate fell 8 basis points (bp) to 0.19 percent, while the rates on the 5-year and 10-year securities each fell 20 by to 0.91 percent and 2.20 percent, respectively. So, even though no open market operations were used to adjust interest rates, the rates trading today responded to a change in their expected future values.

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This idea of a future market value is better highlighted by looking at a type of derivative called a federal funds rate future contract. These contracts allow banks to borrow interbank (federal) funds at a specified rate at some date in the future. When the FOMC announced its commitment to keep the federal funds rate in the 0 to 25 bp range until the middle of 2013, the futures contracts shifted downward dramatically to incorporate the expectation that the federal funds rate would remain low. For example, on the day before the announcement, the June 2013 future contract was trading at a price that implied a federal funds rate of 38 bp. Following the meeting, the same June 2013 contract implied a federal funds rate of 20 bp, back in the target range currently adopted by the FOMC. …