Monetary policy surprises and interest rates: choosing between the inflation-revelation and excess sensitivity hypotheses.

• Author: Thorbecke, Willem

Romer and Romer (2000) reported that federal funds rate increases may raise expected inflation by revealing the Federal Reserve's private information about inflation. Gurkaynak, Sack, and Swanson (2005a) presented evidence that funds rate increases lowered long-term expected inflation. To choose between these hypotheses, we examine how monetary policy surprises affect daily traded commodity prices, term interest rates, and forward interest rates. We find that funds rate increases in the 1970s raised gold and silver prices and that increases after 1989 lowered gold and silver prices. We also find that funds rate hikes over both sample periods primarily affected short-term interest rates and near-term forward rates/For the 1970s, these results suggest that Romer and Romer's explanation is correct. For recent years, they indicate that funds rate increases affect real rates and may also be consistent with the findings of Gurkaynak, Sack, and Swanson.

JEL Classification: E43, E52

1. Introduction

   Why do increases in the Federal Reserve's (Fed's) target for the federal funds rate raise interest rates on long-term Treasury securities? One might expect that contractionary monetary policy would raise short-term rates because of a liquidity effect and reduce long-term rates by lowering expected inflation. Yet Cook and Hahn (1989) reported that increases in the Fed's target for the federal funds rate from September 1974 to September 1979 raised interest rates at all horizons. Similarly, Kuttner (2001) found that unanticipated increases in the federal funds rate target over the June 1989 to February 2000 period increased interest rates at all maturities.

   One interpretation of the results of Cook and Hahn (1989) and Kuttner (2001) is that contractionary monetary policy raises longer-term real interest rates. The nominal interest rate equals the real interest rate plus the expected inflation rate. If contractionary monetary policy lowers expected inflation or leaves it unchanged, then evidence that it increases the nominal interest rate implies that it must also be increasing the real interest rate.

   Romer and Romer (2000) provided an alternative explanation for these findings. They showed that the Fed has substantially more information about future inflation than is available from commercial forecasts. Their results imply that the optimal strategy for individuals with access to both the Fed's forecasts and commercial forecasts would be to rely exclusively on the Fed's forecasts. They also demonstrated that Federal Reserve policy actions reveal some of the Fed's private information about inflation. An increase in the federal funds rate target could thus increase interest rates by raising expectations of future inflation.

   Gurkaynak, Sack, and Swanson (2005a) presented evidence indicating that increases in the federal funds rate target have the opposite effect, lowering expected inflation from 1990-2002. They found that unexpected increases in the funds rate target lower the one-year forward rate 10 years ahead. They also found that real long-term forward rates derived from inflation-indexed Treasury securities do not respond to monetary policy surprises, while the compensation for inflation responds with a significant negative coefficient to positive innovations in the federal funds rate target. They interpreted these findings to mean that surprise increases in the federal funds rate target lower future expected inflation. Their conclusion is thus exactly the opposite of Romer and Romer's (2000) information-revelation explanation.

   Ellingsen and Soderstrom (2001) presented a model that encompasses the models of Romer and Romer (2000) and Gurkaynak, Sack, and Swanson (2005a). In their model unanticipated changes in the central bank rate can occur because the central bank has private information about the economy or because the central bank changes its preferences for inflation stabilization relative to output stabilization. Romer and Romer focused on the first effect, and Gurkaynak, Sack, and Swanson focused on the second.

   Campbell (1995) noted that the effect of funds rate increases on inflation expectations should depend on the Fed's credibility in fighting inflation. If the Fed's anti-inflationary policies are credible, then they should forestall increases in longer-run expected inflation. If they are not credible, then they may increase both shorter-term real rates and longer-term expected inflation.

   Bernanke and Mishkin (1997) have argued that central bank credibility in financial markets depends on delivering low inflation. Inflation in the United States in the 1970s was high and volatile, while inflation since 1990 has been quiescent. Thus, as Yellen (2006) discussed, the Fed's credibility was much weaker in the 1970s than it is now. (1)

   The response of financial markets to news of funds rate changes might thus have been different in the 1970s than in more recent years. In the 1970s a funds rate increase, in addition to raising short-term real rates, might have increased expected inflation through the channel discussed by Romer and Romer (2000). In the 1990s and the first decade of the 21st century a funds rate increase, rather than leading investors to anticipate higher inflation, might have led them to believe that the Fed would be tougher on inflation. It could thus have lowered expected inflation.

   One way to test whether monetary policy surprises affected inflation expectations differently in recent years than in the 1970s is to look at how they impacted daily traded commodity prices. (2) Commodities such as gold and silver are widely regarded as hedges against inflation. The evidence of Gurkaynak, Sack, and Swanson (2005a) implies that unexpected increases in the federal funds rate after 1990 lowered longer-term expected inflation and raised short-term real interest rates. Frankel and Hardouvelis (1985), Hardouvelis and Barnhart (1989), Frankel (2008), and others have shown that if monetary policy actions are expected to increase real interest rates they will lower commodity prices, and if they are expected to lower inflation they will also lower commodity prices. Thus, if positive federal funds rate innovations are having the effects posited by Gurkaynak, Sack, and Swanson (2005a), they should unambiguously lower commodity prices. On the other hand, the evidence of Romer and Romer (2000) indicates that funds rate increases raise short-term real interest rates and raise longer-term expected inflation. Higher short-term real interest rates would lower commodity prices and higher expected inflation would raise them. Thus, if funds rate hikes are having the effects posited by Romer and Romer (2000), they may either raise or lower...