Market Expectations for Monetary Policy in the U.S. and Europe
On March 16, the Federal Open Market Committee (FOMC) released a statement saying it would hold the Federal Funds target rate at 0 to 1/4 percent, and that “low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” The Committee also confirmed that the end of March would see the sunset of Fed purchases of agency mortgage-backed securities and agency debt, which have been executed in the amounts of approximately $1.25 trillion and $175 billion, respectively, over the past year.
Was the market surprised by anything in this statement? One measurement of expectations—Eurodollar futures—suggests not. Eurodollar deposit rates are the rates paid on large deposits of dollars in foreign banks. Eurodollar futures are contracts to lend Eurodollars at a given interest rate for a particular length of time at a specified future date. The market for these instruments is heavily traded, and therefore it provides a reliable gauge of how the capital markets expect short-term, dollar-denominated interest rates to move in a set period of time. (Typically, we would look at federal funds futures to gauge market expectations for short-term rates, but this market has not been functioning normally with fed funds rates near zero.)
The chart below shows the interest rates associated with 90-day Eurodollar futures to be delivered between June 2010 and December 2012. The upward slope of the curve indicates that markets are pricing in an increase in short-term interest rates over the next year and half. Since there is not much room for rates to go anywhere but up, this isn’t really surprising or insightful. It is more useful to compare the curve prior to the March 16 FOMC meeting and after it. Doing so, we see that the curve experienced a parallel shift of about 5 basis points (0.05 percent) following the meeting. There was some downward revision of expectations, but not much—the market basically got what it expected from the FOMC statement: low rates for an “extended period.”
Interest rates on euro-denominated contracts, however, have fallen further than their dollar-denominated counterparts. In the same period around the FOMC meeting, expectations for short-term euro rates fell 9 or 10 basis points. What’s more, the crossing of the dollar and euro curves shows that while euro rates are currently above those of dollar rates, the market expects the monetary policy in the euro-area to stay looser for longer than in the United States. This may have to do, in part, with fiscal concerns about a number of European countries.
As has been heavily reported in the financial press, Greece’s budget deficit this year (in the double-digits as a percentage of GDP) has prompted concern about the near-term sustainability of its fiscal policy. Although Greece is small relative to many of its European neighbors, its fiscal situation and debt market troubles have also brought suggestions that other, larger EU countries—like Spain and Italy—may themselves be increasingly risky to creditors because of similar fiscal imbalances.
The perceived credit risk of these countries is best seen in their credit default swap spreads. Protection against a Greek government default is more than six times as expensive as similar protection against a default by Germany, which is the largest EU economy and one with a stronger fiscal outlook. Protection against default for two other large European countries—Spain and Italy—is more than twice as expensive as for Germany. The implications of these fiscal developments for issues of financial stability and economic fragility may well keep monetary policy, and thus short-term interest rates, loose in the euro area longer than in the United States.