K. Alec Chrystal

English

Research Papers in Economics

FEDERAL RESERVE BANK OF ST. LOUIS REVIEW JULY/AUGUST 2008 395
Commentary
Alec Chrystal
“cleaner” money market interest rate that contains
the same information but avoids the complexities
of moving-average valuation. Could we, for exam-
ple, do roughly the same exercise with short-
term Treasury bill discount rates, short maturity
Treasury bond yields, or indeed interbank loan
rates? If we could, then it would surely be simpler
to use these rates and parsimony would lean in
their favor.
Assuming now that the federal funds futures
prices are the best proxy for market expectations,
what do the results tell us, and what else might
we like to know? The results reported in this
paper confirm two earlier findings: First, market
rates anticipate actual policy rate changes and,
second, other market rates (yields to maturity)
move with the federal funds rate, including those
of up to 10-year maturity. I will discuss each of
these in turn.
It is not a major surprise to find that markets
anticipate policymakers’ decisions. That this is
highly likely has been central to economics since
the rational expectations revolution of the 1970s.
However, it would be interesting to know if mar-
kets have become better at doing this over time
and whether this ability has been affected by
improved transparency about the target rate, the
stated biases in the policy stance, and what is
being targeted. Similar questions apply to the
unexpected component of policy changes: Has
the impact of policy changed over time, and are
the results for the full sample dependent on spe-
cific periods or specific sets of events?
I
am very pleased to be asked to participate
in this conference that honors the career
of Bill Poole. As a student of monetary
economics I, like all my generation, was
substantially influenced by Poole (1970). I was
pleased to meet him many times at the annual
St. Louis economic policy conference, both before
and after he became president of the Federal
Reserve Bank of St. Louis. We were also very
grateful that he came to London in 2000 to give
the annual Henry Thornton Lecture at the Cass
Business School of City University.
I now turn to my comments on Professor
Hamilton’s (2008) paper. The paper uses data
from daily movements in federal funds futures
to test for links between futures prices, the policy
rate itself, and the behavior of market interest rates.
I first comment on the empirical work presented
and then suggest additional avenues of research
to further enlighten the topic. I then ask this:
Who might be interested in these results and
what might they learn from them?
Some of the difficulty in using the federal
funds futures price as an indicator of market
expectations arises from the fact that the contract
settles on an average daily price over a month. I
do not wish to get into the institutional detail here
or into the econometric problems this causes,
not least because I am dominated in institutional
knowledge by Ken Kuttner, the other discussant,
and in econometric expertise by Professor
Hamilton himself. However, as a naive outsider,
I cannot help but ask whether there is some
Alec Chrystal is a professor of money and banking and associate dean and head of the faculty of finance at Sir John Cass Business School,
City University, London, England.
Federal Reserve Bank of St. Louis Review, July/August 2008, 90(4), pp. 395-97.
© 2008, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect the
views of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. Articles may be reprinted, reproduced,
published, distributed, displayed, and transmitted in their entirety if copyright notice, author name(s), and full citation are included. Abstracts,
synopses, and other derivative works may be made only with prior written permission of the Federal Reserve Bank of St. Louis.A slightly different point arises in the context
of testing the effects of federal funds futures on
other market rates. It makes sense that short rates
move most closely with the federal funds rate.
However, the theoretical link with long rates is
rather more ambiguous. In what way should long
rates react to changes (and expected changes) in
short-term policy rates? This could go either way,
and indeed there could be no link at all. Suppose
the Fed is tightening rates in order to bring down
inflation in the future. This will raise implied
forward rates up to some term, but it may lower
interest rate expectations further out, that is, tip
the yield curve. In such cases, forward rates further
out will change but the change could quite logi-
cally be in the opposite direction. Tighter policy
now could lower inflation expectations further
out and, hence, create expectations of lower inter-
est rates in the future. Hence, it might be interest-
ing to test the reaction of long forward rates, in
addition to yields to maturity, as the former will
strip out the impact at the short end of the yield
curve. What actually happens in each case will
be dependent on the complexity of the environ-
ment, and the reaction might be asymmetric—
rises may have a different impact than falls.
Why and to whom is all this likely to be
interesting? Potentially there are three groups
who may be able to learn something from the
relationships that emerge from this and similar
studies: first, the monetary authorities themselves;
second, market participants who trade in these
and related markets; and third, those in the eco-
nomics profession who want to understand how
monetary policy works, that is, those with an
interest in the transmission mechanism.
The monetary authorities may be interested
in all this for two possible reasons. First, by moni-
toring the federal fund futures they can see what
the markets expect policy to be and can factor
that into their decisions. Second, they could
understand what impact an unexpected rate
change has on the markets. (I will return later to
the issue of whether these results mean that only
unexpected rate changes matter.) I do not know
for sure, but my guess is that Federal Open Market
Committee members have reliable ways of back-
ing out market expectations and of estimating
the impact of their policy rate changes without
having to rely on this evidence from the federal
funds futures market. Hence, I suspect that the
contribution of these results to policymakers’
decisionmaking is quite small.
Market participants have little to learn from
these results because the federal funds futures
prices reflect their behavior in the first place, so
they are not going to learn about their own expec-
tations from a price that their behavior has created.
There may be something that these players could
learn from federal funds futures prices, but only
if the data were much more finely sampled.
Tick-by-tick data for this and other closely linked
money markets might help to identify exactly
where changes in sentiment first appear. Market
traders probably know this already, but it is also
possible that the news for some episodes appears
to some segments of the market first. However, it
is more likely that market participants get new
information more or less simultaneously and the
timing of market movements is purely a product
of how we measure the “market price.” That is,
all prices respond as quickly as is technically
possible to the same information.
So what can we as economists learn from all
this about the transmission mechanism of mone-
tary policy? I suggest that this evidence does
nothing but confirm what we already knew: Mar-
kets anticipate what policymakers are going to do,
and markets move most when the policy change
is most unexpected. However, I should emphasize
that this evidence neither supports nor confounds
the old notion of the Lucas aggregate supply curve,
by which only unexpected policy changes have
real effects.
To see this, I hypothesize that monetary policy
works through a number of channels to influence
aggregate demand in the economy. Only one of
these channels is the direct effects on other market
interest rates. Other channels include asset prices
(and thus wealth effects), expectations and con-
fidence, and international financial markets (and
thus the exchange rate). The fact that market rates
anticipate policy rate changes does not mean that
the changes have no effect; it just means that the
effects happen sooner. Market rate changes will
still affect saving and investment decisions and
Chrystal
396 JULY/AUGUST 2008 FEDERAL RESERVE BANK OF ST. LOUIS REVIEWthus also aggregate demand. They will also affect
asset valuations and thus create wealth effects.
Unexpected policy rate changes may well
have a bigger measurable impact on market rates
of all maturities, but this does not prove either
that only unexpected rate changes have real effects
or that unexpected rate changes have bigger real
effects. It remains possible that unexpected pol-
icy changes have a bigger impact on aggregate
demand, but the evidence adduced here does not
address this issue.
In short, this paper contains some outstanding
innovative econometric work that throws much
light on the links between federal funds futures
prices, the policy rate, and other market rates.
However, the results have no apparent implica-
tions that should cause us to revise our view of
how monetary policy works.
REFERENCES
Poole, William. “Optimal Choice of Monetary Policy
Instrument in a Simple Stochastic Macro Model.”
Quarterly Journal of Economics, 1970, 84(2),
pp. 197-216.
Hamilton, James D. “Assessing Monetary Policy
Effects Using Daily Federal Funds Futures
Contract.” Federal Reserve Bank of St. Louis
Review, July/August 2008, 90(4), pp. 377-93.
Chrystal
FEDERAL RESERVE BANK OF ST. LOUIS REVIEW JULY/AUGUST 2008 397398 JULY/AUGUST 2008 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW

Assessing Monetary Policy Effects Using Daily Federal Funds Futures Contract.” Federal Reserve Bank of St. Louis Review,

Optimal Choice of Monetary Policy Instrument in a Simple Stochastic Macro Model.”

Commentary on "Assessing monetary policy effects using daily federal funds futures contracts"

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Commentary on "Assessing monetary policy effects using daily federal funds futures contracts"

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