Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Announcement Effect: Evidence from Open Market Desk Data

Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Announcement Effect: Evidence from Open Market Desk Data

Article excerpt

I. INTRODUCTION

The textbook view of the monetary transmission mechanism rests on the central bank's ability to manipulate the overnight interest rate by controlling the reserve supply, followed by a rational-expectations mechanism that ensures that movements in the overnight rate reverberate into longer maturity rates. However, while few dispute the fact that the central bank controls the overnight rate effectively, the notion that it does so via a liquidity effect and the nature of term structure relationships needs to be reexamined.

Modern central banking is generally characterized by public announcements of an interest rate target, such as the federal funds rate target in the United States. In some cases, central banks (such as the Bank of Australia and the Bank of England) also disclose an inflation target, while in extreme cases, the banks (such as the Reserve Bank of New Zealand) disclose the parameters of the policy reaction function. These actions constitute a significant departure from traditional central banking.

It is natural to question why central banks have abandoned their once-secretive behavior in favor of public disclosures of policy moves. Likely reasons include the desire for better and more precise control of the overnight rate, and, more important, enhanced communication of future policy moves-in essence, the Holy Grail of controlling long rates by also manipulating expectations.

This paper investigates these issues as they relate to the U.S. Federal Reserve. In particular, we focus on how the Federal Reserve's 1994 policy change-by which it began announcing the target level for the federal funds rate-had an impact on the liquidity effect and the manner in which the central bank uses open market operations to control the federal funds market. We also examine what effect this policy change may have had on the behavior of the term structure.

Prior to the Federal Reserve's Federal Open Market Committee (FOMC) meeting in February 1994, monetary policy objectives for the federal funds rate and the outcome of the FOMC meeting itself had been confidential and had never been announced.1 After the policy change occurred, and inspired by similar developments in other central banks, Demiralp and Jorda (2000), Guthrie and Wright (2000), Taylor (2001), Thornton (2001), and Woodford (2000) began to investigate a central bank's ability to control the overnight rate-not merely through traditional open market operations, but by effectively communicating the desired level of the overnight rate and standing ready to enforce that level. As Meulendyke (1998) observes, "the [federal funds] rate has tended to move to the new preferred level as soon as the banks know the intended rate." In this paper, we term this method of controlling the overnight rate the announcement effect (following Demiralp and Jorda [2000]); this effect differs from the conventional liquidity effect in that the volume of open market operations required to signal the new target level is substantially smaller because of expectations.

The strategy we pursue to investigate the announcement effect consists of using two types of controls. The first is to analyze the data with two primary subsamples: one predating and the other postdating the 1994 policy change. The second is to compare, within a subsample, the pattern of open market operations surrounding days in which the target was changed relative to the rest of the subsample.

Most of the time, open market operations conducted by the Trading Desk of the Federal Reserve Bank of New York ("the Desk") are designed to accommodate variations in the reserve needs that stem from a variety of factors, such as changes in currency holdings, float, and large Treasury balances; to manage currency in circulation; and to accommodate other variations in the supply of reserves. Based on a particular type of variation (unexpectedly large Treasury balances), Hamilton (1997) calculates the interest rate elasticity to an unanticipated shortfall in reserves. …

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