The Policy Anticipation Hypothesis: Evidence from the Federal Funds Futures Market

I. INTRODUCTION On 2 June 2000 the U.S. Labor Department released a report indicating an increase in the unemployment rate and a surprisingly small increase in nonfarm payrolls. Bloomberg.com filed the following report: "U.S. unemployment rose to 4.1 percent in May and the number of non-government jobs fell for the first time in more than four years. The unexpected news sent stocks and Treasury securities higher as pressure for higher interest rates eased." There exists a vast body of literature documenting the reaction of financial markets to macroeconomic announcements. Equation (1) represents a regression commonly encountered in the literature. (1) [DELTA][B.sub.t] = [alpha] + [n.summation over (j=1)][[beta].sub.j]([x.sub.jt] - [x.sub.jt.sup.e]) + [u.sub.t] Studies using equation (1) test the impact of the surprise component of macroeconomic announcements (x - [x.sup.e]) on the change in bond yields ([DELTA]B). Hardouvelis (1988), Edison (1997), Cook and Korn (1991), and Fleming and Remolona (1999a) tend to find significant [beta]'s for a number of macroeconomic announcements, indicating that bond yields respond to macroeconomic news. The reaction of the bond market to these announcements has been well documented, but the explanation for the bond market's response is still open for debate. One theory, which is referred to as the policy hypothesis (PAH), suggests that bond yields react to economic news because of its implication for future monetary policy decisions. (1) For example, strong economic news leads market participants to expect a future tightening of monetary policy, and this pushes bond yields higher. This article seeks to evaluate the extent to which policy anticipation can explain the response of bond yields to macroeconomic announcements. The minutes from the 22 August 2000 meeting of the Federal Open Market Committee (FOMC) reveal that policy makers put credence in PAH. Other interest rates generally moved lower over the period, extending the declines that had begun during the spring. Factors contributing to the most recent reductions included economic data releases that were viewed, on balance, as confirming earlier indications that demand growth was slowing to a more sustainable pace and that price pressures would remain damped, thereby lessening or potentially obviating further tightening of monetary policy. (2) In this case the decline in interest rates is being attributed to macroeconomic announcements that revealed a slowing of economic activity. This slowing of demand growth impacted expectations of future monetary policy, which caused an immediate decline in interest rates. Amato et al. (2002) describe the impact of policy anticipation on bond yields as a doubleedged sword for policy makers, on one hand limiting the information that can be gleaned from financial markets, and on the other hand opening up an additional channel of policy influence. To the extent that the PAH holds, policy makers must be careful when looking to market interest rates for signals about the strength of aggregate demand or inflation expectations, because in the extreme case the bond market will simply mirror policy expectations. The impact of policy anticipation on bond yields does, however, create an opportunity for policy makers to manage expectations and influence the position and shape of the yield curve. Along these lines central banks are increasingly making efforts to become more transparent in their decision making and communications. The Federal Reserve, for example, has recently begun a research program to study the effectiveness of their communication with the public. Kohn and Sack (2003) find that FOMC statements and congressional testimony by Chairman Greenspan convey important information to market participants and even suggest that these forms of communication may provide the Federal Reserve with an additional policy instrument. …