Evolving market perceptions of Federal Reserve policy objectives

(ProQuest: . denotes formulae omitted.)The Federal Reserve Act states that the goals of monetary policy are "maximum employment, stable prices, and moderate longterm interest rates. " Policymakers have interpreted the exact meaning of these goals differently over time depending on economic conditions and their understanding of the economy. For example, during the Volcker era when inflation was deemed excessive, policymakers placed a high priority on lowering inflation even at the expense of high and rising unemployment. During the Greenspan era, as further disinflation was achieved, policymakers emphasized "sustainable economic growth," with a view that such an outcome could be achieved only in an environment of low and stable inflation. Finally, in the aftermath of the financial crisis and soaring unemployment, the Federal Open Market Committee (FOMC) under Chairman Bernanke made explicit the nature of its "dual mandate. " The Committee specified a longer-run numerical objective for inflation and provided estimates of the unemployment rate that in the long run would be consistent with maximum employment. In addition, the FOMC tied its expected path for the federal funds rate target to an unemployment rate threshold, provided inflation one to two years ahead remained below 2½ percent.Have these evolving interpretations of Federal Reserve objectives influenced the way financial markets view monetary policy? In particular, have they affected market perceptions about how policymakers might respond to incoming news about economic conditions? This article examines these issues based on the idea that longer-term interest rates reflect the markets' view about the FOMC's setting of its target path for the federal funds rate. It shows that, despite apparent shifts in the way the FOMC has communicated about its objectives, the response of long-term interest rates to economic news has remained relatively stable over time. This finding suggests that market participants perceive little change in how the FOMC adjusts the federal funds rate in response to incoming information.Section I describes the history of the Federal Reserve's legal mandate and the evolution of ideas about the importance of price stability and maximum employment as goals of policy during the Volcker, Greenspan, and Bernanke eras. Section II provides a theoretical framework for understanding how policymakers' views about the relative importance of the two legs of the dual mandate may depend on economic conditions. The section also provides a framework-the expectations theory of the term structure of interest rates, along with the efficient markets hypothesis-for measuring changes in private-sector perceptions of policy objectives. Section III quantifies changes over time in the response of longer-term interest rates to economic news about employment and inflation, taking these changes as an indication of changing market perceptions of Federal Reserve policy. The analysis is based on regressions of the daily change in longer-term interest rates on the unexpected component of various economic news announcements.I. OBJECTIVES OF MONETARY POLICYCongress mandated that the Federal Reserve "promote . maximum employment, stable prices, and moderate long-term interest rates" in the Federal Reserve Reform Act of 1977 (U.S. Congress, 1977). Since then, monetary policymakers have interpreted the practical meaning of this mandate in somewhat different ways, from an emphasis on price stability when inflation was at historically high levels in the late 1970s to a focus on employment when the unemployment rate soared in the Great Recession, ultimately reaching 10 percent.The Federal Reserve's legislative mandateAt its inception in 1913, the Federal Reserve's main focus was to contain and eliminate the banking panics that were common to the time and to establish financial stability. Specifically, the Federal Reserve Act created the Federal Reserve System "to furnish an elastic currency" and "to establish a more effective supervision of banking in the United States," in addition to other purposes (U. …