Interest Rates Have Responded to the Fed’s New Language
At its August policy meeting, the Federal Reserve took the unprecedented step of establishing a specific future date for policy action given current economic conditions. The intention was to clearly communicate to the public that, in light of what is currently known about the economic outlook, the Federal Reserve expects to keep interest rates extremely low for longer than the public previously believed. A quick look at some of the market reaction to the August Federal Open Market Committee (FOMC) statement shows that the change in statement language was successful in altering public expectations of future interest rates and, in turn, current interest rates.
This was a unique move in the realm of FOMC policy changes, partly because it was only operational through the language in the Committee's statement, and partly because of the reference to a specific date. The FOMC made a similar move when it added the "extended period" language in March 2009. By making a tentative commitment to not raise interest rates until the middle of 2013, the Committee was attempting to alter the expectations of market participants. It worked. Since the announcement, forecasts for a variety of interest rates have fallen, at least in part due to the lower expectations for future interest rates.
Despite the emphasis on expectations, this shift out in time for raising short-term interest rates has also had influences on current interest rates. The yields on Treasury securities maturing within one year were already at extremely low rates, but yields on maturities of 2 years or longer have fallen noticeably since the announcement. The 2-year Treasury rate fell 8 basis points (bp) to 0.19 percent, while the rates on the 5-year and 10-year securities each fell 20 bp to 0.91 percent and 2.20 percent, respectively. So, even though no open market operations were used to adjust interest rates, the rates trading today responded to a change in their expected future values.
This idea of a future market value is better highlighted by looking at a type of derivative called a federal funds rate future contract. These contracts allow banks to borrow interbank (federal) funds at a specified rate at some date in the future. When the FOMC announced its commitment to keep the federal funds rate in the 0 to 25 bp range until the middle of 2013, the futures contracts shifted downward dramatically to incorporate the expectation that the federal funds rate would remain low. For example, on the day before the announcement, the June 2013 future contract was trading at a price that implied a federal funds rate of 38 bp. Following the meeting, the same June 2013 contract implied a federal funds rate of 20 bp, back in the target range currently adopted by the FOMC.
Another way to see how this policy has worked is to look at a similar Treasury yield curve as the picture above, this time with forecasts for future interest rates. The monthly forecasts highlighted below come from a survey of economic forecasters. Forecasts for Treasury yields at the end of 2011 have declined markedly from September to August, especially beginning at the 2-year maturity, where expected rates fell 40 bp to 0.30 percent. Larger monthly declines were also apparent for securities with longer maturities. Forecasts for the end of 2012 were revised even more dramatically from August to September, falling by an average of more than 100 bp across the yield curve. Admittedly, though, the large changes in these forecasts from August to September reflect more than just the Federal Reserve's policy change; factors such as disappointing news about the strength of the economic recovery also pushed down forecasts of interest rates from August to September.
One interesting aspect of these changes in forecasts of the yield curve is the shift in both short-term and long-term interest rates. This shift is especially visible in the forecasts for the end of 2012. Forecasts for the federal funds rate in late 2012 fell from over 1.00 percent to less than 0.25 percent. Similar declines could be seen for other short-term rates like the 1-month commercial paper rate and the 3-month LIBOR, each of which shed 75 to 100 bp from their December 2012 forecasts. The change in policy seems to have shifted expectations for interest rates across the maturity spectrum.
But since short-term rates are now expected to rise less quickly, long-term investors will demand lower long-term interest rates. This is apparent in the downward shift in forecasts for long-term interest rates. Highly-rated corporate bond yields in December 2012 were expected to be 5.60 percent in August, but September's forecast is for a 4.80 percent yield at the end of 2012. Similar declines occurred for the forecasts of lower-rated corporate bond yields and for home mortgage rates.
Clearly, the August announcement comes with some caveats. Most importantly, this policy commitment is conditional on the economy evolving as expected based on the information available at the time of the August FOMC meeting. Should the economy improve more rapidly or slowly than expected today, or should inflation prove either higher or lower than anticipated, the timing of the first increase in the federal funds rate target could change. But as intended, the announcement has had significant effects on current market interest rates, as well as the forecasts for those interest rates in the future.