Eurodollar Futures, Taylor Rules, and the Conduct of Future Monetary Policy
When interest rates are zero and policymakers would like to lower rates further, the usual monetary policy operations are no longer effective. Traditional open market operations, in which the Fed swaps collateral into or out of the financial system for cash, can’t affect rates—or economic activity—because short-term bonds and excess bank reserves are perfect substitutes in a zero-interest-rate environment. The substitutability means that when the Fed buys short-term debt from banks, that does not insure that the money banks are receiving in payment will be lent out. Instead, banks simply substitute the T-bills that were on their balance sheet (which effectively earn zero percent interest) with excess reserves. When open market operations (with short-term bills) only increase the balances of excess reserves, the operations will be ineffective in increasing prices and output. This substitutability is one reason that the level of excess reserves exploded during the recent recession.
Monetary authorities must instead find alternative ways of stimulating the economy and increasing inflation. One policy option is to signal the future path of interest rates. Monetary policy is not given by just today’s funds rate but the path of future funds rates as well. By promising low rates not just today, but also in the future, long-term rates can also be reduced. This reduction in long-term rates increases investment and thus output.
In order to achieve lower expected long-term interest rates, the Fed needs to convey a message to the markets that alters their expectations for the policy rate path going forward. Some elements of the Fed’s recent Federal Open Market Committee (FOMC) statements might suggest that it is sending such a message. In the last several statements, the FOMC said: “The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate …exceptionally low levels of the federal funds rate for an extended period.”
But the lines omitted in that excerpt are very important, as they seem to indicate that the reason the funds rate will be low is because of “economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations.” If low rates are solely due to the fact that the Fed will continue to respond to inflation, output, and the output gap as it typically does, then the Fed’s statement will not stimulate the economy since it is not affecting the anticipated course of future policy.
To investigate whether the markets expect future funds rates to be lower than what would normally occur given the current state of economic conditions, we need a way of ascertaining how policy has typically responded to economic conditions as well as a measure of what markets expect. For the policy reaction function we can use a Taylor-type interest rate rule. While there are many possible economic conditions on which the Fed can base its rate decisions, we include inflation, current output growth, and lagged federal funds rates. The following chart illustrates that such a simple “rule” tracks the funds rate quite closely.
The question is whether markets expect future fed funds rates to be higher or lower than would be predicted by this rule going forward. To extend this Taylor-type rule we use internal forecasts of inflation and output growth. To get an idea of what markets expect for the future path of the funds rate we use Eurodollar futures, correcting for the risk in the Eurodollar market that is not present in the fed funds market. These futures are thought to be a good estimate of market expectations of future funds rates.
If we start this analysis in April, we see that the market was expecting much higher funds rates in the future than would have been expected given the forecasts for future economic conditions. In April, future policy by this metric was not accommodative but was actually restrictive.
But by the June FOMC meeting the situation had changed dramatically. Now the market’s expectation of future funds rates was almost always below what would be expected from a Taylor-type interest rate rule. This indicates that future policy was now accommodative. These market expectations had fallen on the big news around this time of debt concerns in Greece and Portugal.
Repeating this analysis for early September, we see that market forecasts and a Taylor-type rule are very similar, suggesting that future policy is neither more restrictive nor accommodative than would typically be expected from economic conditions. Extending the market’s expectations out even further by promising low rates for a “hyperextended” period of time is likely to be stimulative. But the impact of such a language change will probably be minimal, given that markets are already expecting the next funds rate increase to occur in the middle of 2012.