Paper for a conference sponsored by the Federal Reserve Bank of New York entitled Financial Innovation and Monetary TransmissionOpen market operations ; Monetary policy ; Federal Open Market Committee ; Federal funds market (United States)

Charles L. Evans

English

Research Papers in Economics

FRBNY Economic Policy Review / Forthcoming 1
I. Introduction
he past ten years have witnessed a remarkable resurgence 
of interest in the relationship between monetary policy, 
economic fluctuations, and inflation. Important research by 
Bernanke and Blinder (1992), Sims (1992), and Taylor (1993) 
refocused considerable attention on the way in which the 
Federal Open Market Committee (FOMC) sets the federal 
funds rate relative to the state of the economy and how these 
monetary policy rules affect the evolution of the economy. 
Virtually all of this literature assumes that the Federal Reserve 
can instantly and continuously set the federal funds rate equal 
to its target funds rate. In fact, a large quantity of resources at 
the Federal Reserve Bank of New York is directed at keeping the 
effective federal funds rate close to the target rate. On any given 
day, large quantities of funds may be injected or withdrawn 
from financial markets in order to reach this target. In practice, 
it could be that only small injections are necessary to hit a target 
rate that is well-known and announced to all participants. 
How does the Federal Reserve Bank of New York’s Trading 
Desk actually implement the instructions from the FOMC, and 
what can macroeconomists learn from this action? The paper 
by Selva Demiralp and Oscar Jordá is a carefully executed 
analysis of the announcement effect using high-frequency 
Trading Desk data.
There are three broad questions addressed by their paper. 
First, what is the behavior of  , the deviation of the funds 
rate from its target? Macroeconomic models that use Taylor 
rules or other interest rate feedback rules assume that the 
monetary authority can reach its target with precision and at 
zero cost. Deviations from these rules are often ignored or 
assumed to be exogenous. If these deviations were large and 
persistent, they would require more attention in economic 
models. If the Trading Desk cannot hit the target rate within 
acceptable bounds, economists would have to investigate the 
consequences. Second, how do open market operations 
respond to different aspects of the   deviation? 
Historically, this has been an important issue for signaling 
monetary policy intentions (Feinman 1993), but it seems less 
important now that the FOMC announces the target federal 
funds rate after each meeting. Third, how do financial markets 
respond to changes in the target rate? By looking at the 
response of term rates around the days of target changes, 
implications for term-structure theory can be assessed. There is 
a good deal of research on surprise changes in monetary policy, 
and the empirical analysis here falls into this category. Less 
work has focused on anticipated policy moves. In the context 
of systematic monetary policymaking, understanding these 
latter implications seems to be a high priority.
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Charles L. Evans
The views expressed are those of the author and do not necessarily reflect the 
position of the Federal Reserve Bank of New York, the Federal Reserve Bank 
of Chicago, or the Federal Reserve System.
Commentary
Charles L. Evans is a vice president at the Federal Reserve Bank of Chicago.
T2 Commentary
II. Announcement Effects
Macroeconomic models of the U.S. economy assume that the 
FOMC sets its target rate   and maintains short-term interest 
rates at this target rate over the relevant time period. For 
example, the models in the recent Monetary Policy Rules 
volume (Taylor 1999) generally ignore any specific role for 
money or liquidity. These simplifications can be justified when 
the demand for money is stable and the FOMC injects a 
“sufficient” amount of liquidity to hit its target rate. As 
Demiralp and Jordá discuss, the required injection of liquidity 
depends on expected policy actions. They provide an example 
of how this can work behind the scenes in a larger model. The 
following setup uses their notation for the demand and supply 
of reserves:
(1)                       
(2)                        .
Within this framework, what happens when the funds target 
 falls? If the target change is unanticipated  , then 
reserve demand is unchanged and a large open market 
purchase is required to inject the additional liquidity. If the 
target change is anticipated several days in advance, two 
possibilities arise. First, because current reserve demand falls in 
this instance, the Trading Desk must contract reserves ahead of 
the target easing in order to keep the target funds rate at its 
higher current value. Alternatively, the Desk could accept an 
early decline in the funds rate by not contracting reserves. In 
this situation, on the day the target change is announced, the 
reduction in the effective funds rate will be smaller and the size 
of the liquidity injection will be smaller (since no earlier 
contraction in liquidity was required in this case). These 
smaller effects are referred to as “announcement effects.”
Although these theoretical effects are plausible, there is 
currently an institutional constraint inhibiting this type of 
behavior by the Trading Desk. At the end of each FOMC 
meeting, the Committee votes on the authorization language 
for the Trading Desk over the intermeeting period. Essentially, 
the Committee authorizes the Desk to carry out its current 
policy intentions, whether an explicit interest rate target or a 
borrowing target. Of critical importance, the Desk is not 
authorized to anticipate changes in the instrument target that 
may or may not be adopted at subsequent FOMC meetings. 
Although this is unlikely to be an issue, the Committee has 
adopted a daily review procedure that can be interpreted as a 
monitoring role. On the morning of each business day, a 
conference call is made to discuss the Trading Desk’s daily plan. 
The call includes staff members from the Board of Governors 
ft∗
Rt
d α – ft γEt ft 1 + – () εt + =
Rt
s Rt 1 – β ft 1 – ft 1 – – () + = ∗
ft∗ Et ft 1 + ft = ()
and the New York Fed as well as one of the rotating Reserve 
Bank presidents who is a voting member. 
One interpretation of this procedure is that the Reserve 
Bank presidents are performing a monitoring role, just as 
outside accounting firms provide objective auditing services 
for corporations. By including a voting member of the 
Committee, there is every reason to expect that any deviations 
from the Committee’s directive to the Desk would be 
discovered immediately. Of course, just as the use of external 
auditors does not presume any wrongdoing on the part of 
corporate officers, the participation of a non–New York 
Reserve Bank president does not presume any ill intentions on 
the part of supporting staff. Nevertheless, a prudent safeguard 
is in place.
How does this procedure square with a bit of casual 
empiricism? Following this conference in April 2001, the 
FOMC met on Tuesday, May 15. It was widely assumed in the 
financial markets that the FOMC would cut the target funds 
rate again at this meeting. Prior to the meeting, the target funds 
rate was 4.5 percent, and the futures market had built in the 
near-certain expectation of a target change to 4 percent. On 
Monday, May 14, federal funds opened at 4.43 percent and the 
effective rate for Monday was 4.43 percent. On the day of the 
meeting, the opening rate was 4.25 percent. As expected, the 
target change to 4 percent was announced at 2:15 p.m. and the 
effective rate for the day was 4.22 percent. Although the funds 
market traded below target ahead of the change, it is difficult 
to say whether this was due to market expectations or other 
institutional issues related to middle-of-the-quarter financing 
needs or settlement issues. In any event, the softer funds rate 
ahead of the target change seems to be consistent with a modest 
announcement effect in this case.
III. Responding to Funds Rate 
Deviations
The heart of Demiralp and Jordá’s empirical analysis is in 
Section IV. The funds rate deviations from target are divided 
into three components: NEED, EXPECTED, and SURPRISE. 
A Tobit analysis is used to characterize the movements of 
overnight, temporary, and permanent operations relative to 
these three elements. The empirical results find evidence of a 
liquidity effect from 1984 to 1994 based upon the injection of 
reserves in response to NEED. Demiralp and Jordá also 
indicate that there is evidence of an announcement effect in 
the latter two samples after the FOMC began to indicate its 
target funds rate. Much of the evidence of accommodation FRBNY Economic Policy Review / Forthcoming 3
seems to be based on the lack of responses to expected moves. 
As the authors point out, the smaller samples during these 
periods suggest that the lack of significant responses must be 
interpreted cautiously.
IV. Term Rates
An important issue here is, how do term rates respond to 
changes in the target rate? In one sense, the answer should 
naturally depend on whether the target changes were expected 
or surprises. In the context of futures market data, once the 
market has formed the expectation of a change in target, this 
information should be reflected throughout the term structure 
of interest rates. Consequently, on the day of an FOMC 
meeting in which the Committee changes the target in an 
expected way, there should be no change in term rates. And if 
the Committee surprises the markets at the meeting, term rates 
should respond. These issues can be addressed with fed funds 
futures market data, and Demiralp and Jordá’s Table 7 reports 
mixed results for the expectations hypothesis.
A different approach to this question would focus attention 
on the economy’s driving forces, or shocks. Different economic 
shocks will likely hit the yield curve in different ways. For 
example, all else equal, expansionary aggregate demand and 
aggregate supply shocks have different implications for future 
inflation. If we take the view that monetary policy surprises are 
relatively small and not a major determinant of economic 
fluctuations, then most policy moves are expected responses to 
incoming economic shocks. 
Consequently, most of the actions arising from target 
changes to term rates will occur on the date that the futures 
market determines that a new economic shock has arrived, 
which the FOMC normally responds to later at its meeting. 
Furthermore, the path of expected target changes will be 
necessary for deducing the implications for longer term rates. 
An initial 25-basis-point increase in the target rate could arise 
from an expansionary aggregate demand shock or 
expansionary aggregate supply shock. However, the expected 
paths over the next twelve months would likely diverge due to 
different inflationary implications. Therefore, it would be 
useful to find a way to employ futures market data to shed light 
on the way in which the economy responds to different shocks.References
4 Commentary 
Bernanke, B., and A. Blinder. 1992. “The Federal Funds Rate and the 
Channels of Monetary Transmission.” American Economic 
Review 82, no. 4: 901-21.
Feinman, J. 1993. “Estimating the Open Market Desk’s Daily Reaction 
Function.” Journal of Money, Credit, and Banking 25, no. 2: 
231-47
Sims, C. 1992. “Interpreting the Macroeconomic Time Series Facts: 
The Effects of Monetary Policy.” European Economic 
Review 36, no. 5: 975-1000.
Taylor, J. 1993. “Discretion versus Policy Rules in Practice.”
Carnegie-Rochester Conference Series on Public 
Policy 39: 195-214.
Taylor, J., ed. 1999. Monetary Policy Rules. Chicago: University 
of Chicago Press.
The views expressed are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York, 
the Federal Reserve Bank of Chicago, or the Federal Reserve System. The Federal Reserve Bank of New York provides no 
warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular 
purpose of any information contained in documents produced and provided by the Federal Reserve Bank of New York in any 
form or manner whatsoever.

The announcement effect: evidence from open market desk data : commentary

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