Media Briefings

FINANCIAL MARKETS ARE MORE FORWARD-LOOKING THAN WE THOUGHT: New evidence from their behaviour around Fed policy decisions

  • Published Date: March 2015

Financial markets use forward guidance and macroeconomic indicators to adjust their behaviour much further in advance of the Federal Reserve’s interest rate decisions than is widely understood. That is the central finding of research by Professor Robin Lumsdaine and colleagues to be presented at the Royal Economic Society’s 2015 annual conference.

The study finds that fed funds futures volatility tends to be lower in the days leading up to a meeting of the Federal Open Market Committee (FOMC) than in the weeks or months preceding it. This evidence that the ‘set-up’ for policy announcements has a longer horizon than previously known is particularly relevant as the markets try to anticipate the end of the quantitative easing launched in response to the financial crisis.

Previous studies have considered the immediate market reaction to Fed communications. This new research carefully evaluates the market’s anticipation of such communications and concludes that the Fed’s policy rate intentions have been well-understood by the financial markets. Among the findings:

• Macroeconomic indicators and central bank officials’ congressional testimony are of comparable importance in anticipating communications.
• Macroeconomic releases have stronger effects on days when Fed officials are silent.
• Congressional testimony is more important when it coincides with days when important macroeconomic information is released.

Robin Lumsdaine, one of the study’s authors, comments:

‘People are used to thinking of financial markets as reactionary and instantaneous.

‘Our work suggests a more methodical approach to digesting central bank communications and macroeconomic announcements, one that considers not only the latest news but how that in turn shapes the path of future policy decisions.

‘Financial markets are more forward-looking than we had thought.’

More…

Financial market participants set up for Federal Reserve decisions well in advance of the actual decision, according to research by Dick van Dijk, Robin Lumsdaine, and Michel van der Wel, presented at the Royal Economic Society’s 2015 annual conference. Their study finds that fed funds futures volatility tends to be lower in the days leading up to an FOMC meeting than in the weeks or months preceding it.

As the Fed nears the end of the large-scale quantitative easing that it launched in response to the recent financial crisis, financial markets have shifted their concern to the exact timing of when the Fed will begin to raise interest rates, something widely expected to happen this year.

Although many studies have considered the immediate market reaction to Fed communications, this new research carefully evaluates the market’s anticipation of such communications. The results show that the anticipation (or ‘set-up’) occurs over a much longer horizon than previously known. The authors argue therefore, that to identify fully how information shapes financial market expectations, it is necessary to look much farther back in time.

‘People are used to thinking of financial markets as reactionary and instantaneous,’ says Robin Lumsdaine, one of the study’s authors. ‘Our work suggests a more methodical approach to digesting central bank communications and macroeconomic announcements, one that considers not only the latest news but how that in turn shapes the path of future policy decisions. Financial markets are more forward-looking than we had thought.’

One of the challenges in quantifying how the financial markets are affected by Fed communications is that other news, such as the release of major economic indicators, also plays a role. In looking at both items together, the study finds that macroeconomic indicators and central bank officials’ congressional testimony are of comparable importance.

In addition, although macroeconomic releases have stronger effects on days when Fed officials are silent, congressional testimony is more important when it coincides with days when important macroeconomic information is released.

The researchers’ finding of large anticipatory set-up emphasises the importance of clarity in central bank communications. The potential importance of these communications has been recognised by the Federal Reserve itself, through a series of decisions since 1994 designed to increase transparency.

‘Failure to look back far enough results in inference that attributes much less significance to both Fed communications and macro announcements in shaping fed funds futures prices’, the authors note.

The study’s results, showing that fed funds futures volatility declines as the FOMC announcement draws near, indicate that the Fed’s policy rate intentions have been well-understood by the financial markets.

ENDS


‘Market Set-Up in Advance of Federal Reserve Policy Rate Decisions’ by Dick van Dijk, Robin Lumsdaine, and Michel van der Wel is available as National Bureau of Economic Research (NBER) working paper # 19814.

Robin Lumsdaine (presenter) is the Crown Prince of Bahrain Professor of International Finance at American University’s Kogod School of Business. Dick van Dijk and Michel van der Wel are at Erasmus University Rotterdam.