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APE-3: Expectations Management by Central Banks
What to Expect from the Lower Bound on Interest Rates: Evidence from Derivatives Prices
1Federal Reserve Bank of San Francisco, United States of America; 2Federal Reserve Bank of New York
This paper analyzes the effects of the lower bound for interest rates on the distributions of expectations for future inflation and interest rates. We study a stylized New Keynesian model where the policy instrument is subject to a lower bound to motivate the empirical analysis. Two equilibria emerge: In the ``target equilibrium,'' policy is unconstrained most or all of the time, whereas in the ``liquidity trap equilibrium,'' policy is mostly or always constrained. We use options data on future interest rates and inflation to study whether the decrease in the natural rate of interest leads to forecast densities consistent with the theoretical model. We develop a lower bound indicator that captures the effects of the lower bound on the distribution of interest rates. Qualitatively, we find that evidence is largely consistent with the theoretical predictions in the target equilibrium and find no evidence in favor of the liquidity trap equilibrium. Quantitatively, while the lower bound has a sizable effect on the distribution of future interest rates, its impact on forecast densities for inflation is relatively modest.
How does the Fed manage interest rate expectations?
1Cass Business School, United Kingdom; 2Harvard University
I provide empirical evidence that Fed officials use their speeches to guide short-term interest rate expectations. Measures of misalignment between market and central bankers' expectations predict sentiment in speeches about monetary policy. The voting rotation between Fed Presidents is used as exogenous variation in the incentive to guide market expectations. I show that such communication policy arises in a rational expectations model where the central bank communicates in a discretionary fashion between interest rate decisions. Market expectations can become self-fulfilling when the central bank faces a trade-off between keeping markets calm and its inflation target. The central bank's aversion to bond market volatility and the effect of communication on interest rates are key determinants of the equilibrium link between communication and misalignment.
Gauging the Sentiment of Federal Open Market Committee Communications through the Eyes of the Financial Press
Federal Reserve Board, United States of America
We apply natural language processing tools to news articles in the financial press to construct an index of the perceived semantic orientation of monetary policy communications around Federal Open Market Committee (FOMC) meetings. We then use changes in the index as a measure of monetary policy surprises, and we find that changes in market-perceived FOMC sentiment explain movements in asset prices during narrow event windows around each FOMC meeting between May 1999 and June 2017. We also document that most of this explanatory power appears to be driven by the pre-zero-lower-bound sample period. We compare our results with other sentiment indexes and find that our index has higher explanatory power for movements in various financial asset prices around FOMC meetings, even when we control for financial market-based measures of monetary policy surprises. Our results are robust to a number of alternative specifications of our index and several control variables.
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