Michael Dueker

English

Research Papers in Economics

February 2001
MonetaryTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
The Preemptive Fed
In February 2000, the Federal Open Market
Committee (FOMC) began releasing an assessment 
of the risks of either “heightened inflation pressures”
or “economic weakness.”  This forward-looking assess-
ment suggests that the FOMC is prepared to take pre-
emptive policy actions when warranted.  At the first
seven of its eight meetings in 2000, the FOMC con-
cluded that the risk of heightened inflation pressures
predominated, and tightened policy at the first three of
those meetings.  By the December 2000 meeting, how-
ever, the FOMC judged that economic growth may be
slowing to an extent that the “risks are weighted mainly
toward conditions that may generate economic weak-
ness in the foreseeable future.”  How did financial
markets respond to the policy easing—a 50 basis point
decrease in the federal funds target rate—on January 3,
2001, in light of the risk assessment issued at the
FOMC meeting on December 19, 2000?
To put the reaction of financial markets in context,
note that the FOMC’s press releases on December 19,
2000, and January 3, 2001, described current inflation
pressures as “diminished” and “contained.”  In con-
trast, in the spring of 1990, as the economy was about
to dip into recession, the inflation rate was “uncomfort-
able and unacceptable,” as described by one FOMC
member.  Thus, unlike 1990, the FOMC in early 2001
is not faced simultaneously with a possibly weakening
economy and uncomfortably high inflation.
The accompanying chart shows the responses of
the Treasury yield curve and the forward exchange
rate premium (between the dollar and the euro) to the
recent policy announcements and easing.  The slope of
the yield curve is measured as the difference in yields
between the 10-year Treasury bond and the three-
month Treasury bill.  A strongly inverted (negatively
sloped) yield curve is often considered a sign of a pos-
sible impending recession.  Following the recent policy
easing, the slope of the yield curve increased.  (A
short-lived increase in slope followed the December
19 risk assessment, but it was due to strong year-end
demand for Treasury bills unrelated to monetary policy.)
The forward exchange rate premium is expressed
as the percentage difference between the one-year
forward rate (in dollars per euro) and the spot rate.
Because real interest rates are procyclical, recession
fears would lead to expectations of reductions in real
interest rates in the United States—which generally are
thought to have a negative impact on the future value
of the dollar.  If monetary policy steps are believed 
to reduce the risk of recession, then the forward pre-
mium (in dollars per euro) would be expected to
decrease—precisely what happened following the
January 3 policy easing.
In addition, stock markets responded strongly 
on January 3 to the FOMC policy easing, with the 
NASDAQ posting its largest one-day gain ever. Hence,
a broad spectrum of financial markets—bond, equity
and foreign exchange—reacted to the FOMC’s action
on January 3 in a way consistent with the view that the
policy easing was a preemptive move to lessen the like-
lihood of a recession.
—Michael Dueker

The preemptive Fed

http://research.stlouisfed.org/publications/mt/20010201/cover.pdf

The preemptive Fed

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Research Papers in Economics