Financial markets use Federal Reserve communications and macroeconomic indicators to adjust their behaviour much further in advance of the Fed''s interest rate decisions than is widely understood. That is the central finding of research by Professor Robin Lumsdaine and colleagues, published in the May 2016 issue of the Economic Journal.
The study finds that fed funds futures volatility tends to be lower in the days leading up to a meeting of the Federal Open Market Committee (FOMC) than in the weeks or months preceding it. This evidence that the ''set-up'' for policy announcements has a longer horizon than previously known is particularly relevant given market responses to the recent end of the quantitative easing launched in response to the financial crisis.
Previous studies have considered the immediate market reaction to Fed communications. This new research carefully evaluates the market''s anticipation of such communications and concludes that the Fed''s policy rate intentions have been well understood by the financial markets. Among the findings:
• Of the announcement types studied, previous FOMC announcements are the most important drivers of fed funds futures prices.
• Macroeconomic releases have stronger effects on days when Fed officials are silent.
• Congressional testimony is of comparable importance to the most influential macroeconomic announcements.
Co-author Robin Lumsdaine comments:
''People are used to thinking of financial markets as reactionary and instantaneous.''
''Our work suggests a more methodical approach to digesting central bank communications and macroeconomic announcements, one that considers not only the latest news but how that in turn shapes the path of future policy decisions.''
''Financial markets are more forward-looking than we had thought.''
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Although many studies have considered the immediate market reaction to Fed communications, this new research carefully evaluates the market''s anticipation of such communications.
The results show that the anticipation (or ''set-up'') occurs over a much longer horizon than previously known, suggesting that the effects of both macroeconomic announcements and Fed communications that have been documented in previous studies have been understated. The authors argue therefore, that to identify fully how information shapes financial market expectations, it is necessary to look much farther back in time.
One of the challenges in quantifying how the financial markets are affected by Fed communications is that other news, such as the release of major economic indicators, also plays a role. In looking at both items together, the study finds that macroeconomic indicators and central bank officials'' congressional testimony are of comparable importance.
In addition, although macroeconomic releases have stronger effects on days when Fed officials are silent, congressional testimony is more important when it coincides with days when important macroeconomic information is released.
The researchers'' finding of large anticipatory set-up emphasises the importance of clarity in central bank communications. The potential importance of these communications has been recognised by the Federal Reserve itself, through a series of decisions since 1994 designed to increase transparency.
''Failure to look back far enough results in inference that attributes much less significance to both Fed communications and macro announcements in shaping fed funds futures prices'', the authors note.
''Market Set-up in Advance of Federal Reserve Policy Rate Decisions'' by Dick van Dijk, Robin L. Lumsdaine and Michel van der Wel is published in the May 2016 issue of the Economic Journal. Robin Lumsdaine is at American University''s Kogod School of Business. Dick van Dijk and Michel van der Wel are at Erasmus University Rotterdam.
