President's Message: Predicting the Fed

By

William Poole

Financial markets have been getting better and better at predicting what Federal Reserve policy-makers will do. You can often tell this is true just by reading the daily newspaper.

More rigorous examination than reading the newspaper, however, will lead you to the same conclusion. In research I've been conducting with my colleague Bob Rasche, we've discovered some hard evidence—in the federal funds futures market—that financial markets since 1994 have improved their ability to predict the actions of the Federal Open Market Committee. Today, this market frequently anticipates, sometimes weeks in advance of FOMC meetings, not only the direction of the Fed's change in its federal funds rate target—up or down—but also the magnitude of the change. (As we saw in early January, the market cannot always predict Fed policy actions. Still, that case is an exception to the rule.)

Market success in forecasting Fed policy actions is good news for the economy, for the convergence of financial market expectations and Fed policy actions is at the heart of a successful transmission of monetary policy to the economy. How so? Through financial markets' effect on long-term interest rates. Simply put, if markets expect the Fed's policy actions to be restrictive, they will bid longer-term interest rates up in anticipation of these actions. If markets expect Fed policy actions to ease, they'll lower the rate of return they demand on long-term rates. Thus, the market's recent accuracy in predicting Fed actions means that the market and the Fed are working together to achieve the desired result for the economy.

Some credit for this happy state of affairs must go to the central bank, which has communicated its decisions more openly than ever before. Indeed, after each meeting of the FOMC, the Fed now announces not only whether it is making a change in the intended federal funds rate, but also whether it is leaning in one direction or another in the near term.

The rest of the credit must go to financial market participants, who have observed the Fed's behavior over time, divined its long-term goals and improved their ability to analyze incoming information about the economy as they believe the Fed would. The ultimate goal of the Federal Reserve is to achieve low and stable inflation. The market understands this goal and has become adept at judging what policy actions are warranted to achieve it.

Can we do better? Probably. I'm convinced that the Fed can make its policy decisions and processes even more transparent. If the result will be better synchronization between financial markets and the Fed, it will be an effort well worth it.

For the full text of two speeches on which this column was based, see http://fraser.stlouisfed.org/historicaldocs/wp2000/download/41166/20001130.pdf and http://fraser.stlouisfed.org/historicaldocs/wp2000/download/41167/20001128.pdf

ABOUT THE AUTHOR
William Poole 
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