Assessing New Information: What’s Permanent, What’s Not?
After the Federal Open Market Committee (FOMC) meets to determine its policy rate, it issues a statement to explain its decision. That statement typically includes a sentence to emphasize that future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. Financial market analysts thus keep a keen eye on the flow of new information to assess how it will affect the Committee’s choice of the federal funds rate target at upcoming meetings.
New information often does not affect the outlook enough to warrant a policy action. During the past year, for example, the policy rate—the intended federal funds rate—remained unchanged. Because short-term rates tend to be closely tethered to the policy rate, short-term Treasury yields did not vary much relative to periods over which the policy rate did change.
Although short-term rates varied some, they hovered at levels below the policy rate, providing a sign that market participants expected the next policy action to be a rate cut. To some extent, the movements reflect changes in the expected path of policy, given new information.
Prices of fed funds futures can also be used to infer the expected path of policy actions via their implied yields. Moreover, options based on those futures provide a means to estimate the distribution of those expectations. Implied yields based on futures prices corroborate the view that during the first four months of 2007, market participants built in a projection for rate cuts later in the year, as new information indicated a weaker than expected level of economic activity.
During the late spring, however, incoming data indicated that economic growth was rebounding to a moderate rate. Indeed, on June 13, 2007, implied yields suggested that no rate cut was on the horizon. This change in the expected policy path, however, has not been sustained.
Estimated probabilities for alternative outcomes for the October meeting indicate a similar reaction to the data. Around June 13, 2007, market participants put a higher probability on a rate hike than a rate cut, although neither outcome seemed likely at that meeting.
More recently, the news on inflation has been relatively favorable, increasing the prospect of a rate cut. In sum, incoming news in recent weeks has altered expectations about the path of the fed funds rate, but not in any convincingly permanent way. When looked at in cumulative terms, the outlook seems little changed.
Long-term interest rates have tended to move up in recent weeks. Such rates are typically influenced less by policy actions in the near term. Rather they are influenced more by underlying economic conditions and expectations about inflation. The improvement in the economic outlook no doubt contributed to the recent rise, which seems consistent with a more positive slope of the yield curve.
Ideally, long-term inflation expectations are tightly anchored and hence relatively fixed. However, in his speech yesterday, Chairman Bernanke noted “Although inflation expectations seem much better anchored today than they were a few decades ago, they appear to remain imperfectly anchored.” As an example, the Chairman noted that TIPs-based measures of inflation expectations still move in response to economic data and to current inflation news, “which would not be the case if expectations were perfectly anchored.” Regardless of the variation, there’s no clear change in the pattern of expected inflation.