The Event-Study Activity Puzzle

Introduction and summary If news of higher future interest rates reflects a shift in the stance of monetary policy, then we expect it to lower projections for real gross domestic product (GDP) growth and raise projections for unemployment. However, the data point to quite different conclusions. When market participants raise their estimates of future interest rates after a meeting of the Federal Reserve's monetary policy committee, the Federal Open Market Committee (FOMC), private forecasters tend to raise their projections of real GDP growth and lower their projections for unemployment. Campbell, Evans, Fisher, and Justiniano (2012) documented this fact, and we labeled it the "event-study activity puzzle" in our NBER Macroeconomics Annual chapter (Campbell, Fisher, Justiniano, and Melosi, 2017). In this article, we summarize an empirical exploration of the effects of FOMC statements on financial market expectations of future interest rates and private forecasters' expectations of future macroeconomic performance that appeared in Campbell et al. (2017). Our work resolves the event-study activity puzzle by demonstrating that the FOMC moves market expectations of future interest rates in part by transmitting its views of future macroeconomic fundamentals. When these are strong, private forecasters revise their projections accordingly, while market participants mark up their expectations of future interest rates. How does the FOMC transmit macroeconomic expectations? The FOMC releases a statement after each of its meetings that announces any desired changes to the federal funds rate and other policy tools, describes its assessment of current macroeconomic circumstances, and possibly describes how further developments could influence its future policy choices. This discussion of possible future actions is called forward guidance. Perhaps the most prominent example of forward guidance from before the Great Recession was the use of "the Committee believes that policy accommodation can be removed at a pace that is likely to be measured" in the FOMC's post-meeting statements from May 2004 through November 2005. After the FOMC set its target for the federal funds rate to its effective lower bound in December 2008, it turned to forward guidance as one way to deliver additional monetary accommodation. (1) As demonstrated in the theoretical work of Krugman (1998) and Eggertsson and Woodford (2003), expansionary forward guidance can improve current macroeconomic outcomes if it lowers households' desired savings by increasing their expectations of future inflation and output. According to the theory, such changes in expectations can be induced by the FOMC making a credible commitment to keep the future federal funds rate lower than it would otherwise do given the prevailing macroeconomic conditions. Campbell et al. (2012) called this Odyssean forward guidance. (2) After its August 2011 meeting, the FOMC stated that macroeconomic conditions "are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. " (3) Similarly, it stated after its December 2012 meeting that interest rates would remain exceptionally low "at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. " (4) Both statements could be viewed as Odyssean forward guidance. While the theoretical possibility for appropriate forward guidance to improve current macroeconomic outcomes is clear, the evidence does not unambiguously support this conjecture. Ben Zeev, Gunn, and Khan (2015) and D'Amico and King (2016) both use econometric models and money market futures prices to identify unexpected movements in expected future interest rates caused by FOMC forward guidance; they both find that output and inflation rise presently and in the future when expected future rates fall. …