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Confidence and Central Banking

Fain Lecture in Celebration of George Borts’s Fiftieth Year as aProfessor of Economics at Brown University

Brown UniversityProvidence, Rhode Island

October 14, 2000

My topic is familiar to all economists andmany noneconomists. We know that successfulmarket economies depend on stable and predict-able economic policies. When it comes to mone-tary policy, the key issue is the responsibility ofthe central bank to maintain the public’s confi-dence in the purchasing power of money.

I’m going to discuss the topic, however, in anovel way by tying together confidence in thelarge with confidence in the small. The large issueconcerns stability of the purchasing power ofmoney in the long run. The small issue concernsthe ability of the market to predict the centralbank’s policy actions. By “small” I do not mean“unimportant” but rather small in time. As we’llsee in a moment, in the United States today themarket is quite adept—amazingly so, I think—at predicting what the Federal Open MarketCommittee (FOMC) is going to do at its policymeetings. The two topics—the large one and thesmall one—are connected. For market participantsto believe that the central bank is committed tothe price stability objective, they must also believethat the central bank has the knowledge and willto achieve that objective. The fact that the marketcan predict Fed policy actions FOMC meeting bymeeting suggests that market participants under-stand how the Fed evaluates the complex set ofinformation upon which policy decisions arebased.1 Market understanding of why the Feddoes what it does is essential to the markets hav-

I t is an honor for me to return to BrownUniversity to participate in this celebra-tion of George Borts and his 50 years as aprofessor of economics at Brown. Georgehas been a wonderful friend to me over the years.He is a fine economist and one of a handful ofkey university leaders on the Brown faculty. Hehas shaped Brown and the economics departmentin ways visible and not so visible.

We are going to eat, drink, and be merry a littlelater, and that is certainly appropriate for thisevent. But no celebration of George would be com-plete without a serious economics discussion.During my 24 years at Brown, George and I hadnumerous conversations about economic issues—usually policy issues, for those were the ones wewere most involved in with our own work. Manyof these conversations were over lunch at the IvyRoom or the Faculty Club, most often with col-leagues from economics and other departmentsaround the table. So I think it fitting that I discuss amonetary policy issue that is important not onlyto economists but also to every member of oursociety.

Before proceeding, I want to emphasize thatthe views I express here are mine and do not nec-essarily reflect official positions of the FederalReserve System. I especially thank my St. LouisFed colleague, Bill Gavin, for his extensive assis-tance in preparing this lecture. However, I retainfull responsibility for errors.

1 For research underlying this theme in the lecture, see Poole, William and Rasche, Robert H. “Perfecting the Market’s Knowledge of MonetaryPolicy.” Journal of Financial Services Research, December 2000, 18(2/3), pp. 255-98.

ing confidence that the Fed will be successful inmaintaining price stability.

Before diving intomy topic, it is worth empha-sizing that U.S. prosperity has the characteristicsof a three-legged stool and that all legs are neededfor the stool to stand. One leg is the entrepreneur-ial drive and inventiveness of the private sector.The second leg is the stability of governmentfinances and the regulatory environment. Thethird is confidence in the financial environment,characterized by sustained low and stable infla-tion. It is this third leg I am discussing tonight,but everyone should understand that the othertwo legs are just as important.

FORECASTING FED POLICYDECISIONS

Let’s begin by looking at some recent eventsin financial markets. I’ll examine these events byusing several figures, which appear at the end ofthe text and in a handout everyone should have.

A little background first. The FOMC, the Fed’smain monetary policy body, implements mone-tary policy by setting a target level for the federalfunds interest rate. The Fed calls this target the“intended rate.” Federal funds are simply bankreserves held on deposit at the Federal Reservebanks. Commercial banks borrow and lend thesefunds to each other on an overnight basis. TheFederal Reserve can control the interest rate inthis market—the federal funds rate—by addingor draining bank reserves.

Many observers attribute to the Fed the abilityto control all interest rates. In fact, the Fed’s con-trol over market interest rates other than the fedfunds rate is indirect and operates through marketexpectations about policy objectives and futurepolicy actions. The interest rate on, say, a Treasurybill with a 1-monthmaturity is set in a competitivemarket with no direct Federal Reserve interven-tion. The 1-month rate depends importantly onmarket expectations about the average fed fundsrate over the next 30 days. A 1-year rate dependson expectations about the next 12 1-month rates,

and the 30-year Treasury bond rate depends onexpectations about the next 30 1-year rates.

Expectations about all of these future interestrates depend on expectations about Fed actionsto change, or not to change, the intended rate.And those expectations in turn depend on expec-tations about events and new information thatmay lead the Fed to alter the intended rate. Themain effect of monetary policy, therefore, operatesthrough these expectations about future policyand events that will drive future policy. We know,for example, that changes in the home mortgagerate can have large effects on housing sales andconstruction. The mortgage rate today is tiedclosely to other long-term rates in the capitalmarkets, and all these rates are tied to expecta-tions about future Fed policy.

Now look at Figure 1, which reports daily datafrom the futures market for federal funds. Thefutures interest rate shown here is the market’sbest guess about the average fed funds rate forJune 2000. The figure also shows the level of theFed’s target for the federal funds rate. On May 16,the FOMC raised the intended rate from 6 percentto 6½ percent. This figure shows the interest ratefrom trading in the futures market for the 30 daysbefore and the 30 days after the meeting.

The interesting thing about this figure is theaccuracy of the market’s forecast despite the factthat a fed policy action to change the intendedrate by 50 basis points is a rare event. The firsttrading day shown on the figure is April 4. Onthis day, the intended rate was 6 percent. TheJune fed funds futures contract price reflected amarket expectation that the average fed fundsrate in June would be 6¼ percent. When the Fedchanges the intended rate, the change is usually25 basis points, and that is what the futures marketwas expecting. The June futures rate was steadyuntil the last week of April when it jumped prettyquickly in a couple days. Then it continued torise during the next few weeks, gradually increas-ing to 6½ percent. On May 16, the FOMC votedto raise the intended rate to 6½ percent. Since itis unlikely that the Fed would raise the targetbetween the FOMC meetings—the next meetingwas held on June 27-28—by May 15 the market

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perfectly predicted what the FOMC would do atits meeting the next day.

What do we make of this situation in whichthe market correctly forecasts what the Fed isgoing to do? Is the Fed just following the market?Is the Fed leaking to the market what it intendsto do? Is it a good thing that the market can pre-dict Fed actions? To answer these questions ithelps to consider the relationship between thefutures market and Fed policy actions in moredetail.

FOUR POSSIBLE SCENARIOSFigure 1 illustrates the situation in which the

market correctly forecasts a Fed decision to changethe intended rate. In fact, there are four possiblecombinations to consider. The Fed might changethe intended rate, or not change it, and in eachcase the market might correctly forecast the Fed’sdecision, or not forecast correctly.

Figure 2 contains a matrix of actual examplesfor each outcome from the fed funds futures mar-ket. It is possible that the market anticipates thepolicy decision or that it does not. The two figures

on the left side of Figure 2 show examples wherethe policy decision was correctly anticipated. Thetwo on the right show examples where it was not.Let’s look at these cases a little further.

The upper left panel of Figure 2 shows trad-ing in the futures contract for September 1990 andthe FOMC meeting held August 16, 1990. In thiscase, the futures market expected a relatively large(50-basis-point) increase in the intended fed fundsrate, and the FOMC raised the rate 50 basis points.This case is like the one examined in Figure 1.

The upper right panel of Figure 2 showstrading in the futures contract for January 1991and the FOMC meeting held December 18, 1990.Before the meeting, the markets were not antici-pating that the FOMC would reduce the intendedrate; the rate for the January futures contract didnot fall until after the FOMC acted. In fact, duringthe life of this contract, the FOMC reduced thefed funds target three times and each changeappears to have surprised the market.

The two panels in the bottom half of Figure 2show examples where the FOMC’s decision wasto leave the intended rate unchanged. The bottomleft panel shows trading in the futures contractfor June 1995 and the FOMC meeting held May23, 1995. In this case, the markets expected no

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Figure 1

Fed Funds Futures and the Fed’s Interest Rate Target

change in the fed funds target and the FOMC leftthe target unchanged.

Finally, the bottom right panel of Figure 2shows trading in the fed funds futures contractfor August 1994 and the FOMC meeting heldJuly 6, 1994. Before the meeting, the marketswere anticipating a large increase in the targetrate, but the Fed did not change the rate at itsJuly meeting. However, in this case the futuresrate did not change much after the meeting; themarket was still expecting the Fed to act, whichit eventually did at its meeting of August 16, 1994.

Before I get into this subject any further, letme mention briefly a few general findings frommy research on this subject, conducted jointlywith my colleague Bob Rasche. For those inter-ested, the working paper in all its mathematicaland statistical glory is available on the St. LouisFed’s web site. Two generalizations from thisresearch: First, the accuracy of market predictionsof Fed policy improved dramatically in 1994.Second, most of the changes in the fed fundsfutures rates are driven by economic news suchas the monthly employment report and the infla-

tion data. A relatively small part of the changesin the futures rates comes on days Fed officialsgive speeches or testimony. Although Rascheand I did not investigate the issue of leaks in ourresearch, I am convinced that leaks are extremelyrare. I know of only one example of a leak since Iarrived at the St. Louis Fed—it received attentionin the press in the spring of 1998—and it onlyindirectly concerned the probable future settingof the intended funds rate anyway.

UNDERSTANDING MARKETSUCCESS IN FORECASTING FEDPOLICY ACTIONS

I’m now going to illustrate the key issuesconcerning market success, or lack thereof, inforecasting Fed actions by analyzing more closelythe case discussed in Figure 1. Let’s put aside therelatively infrequent cases in which speeches ortestimony by Fed officials seem to telegraph Fedintentions. And I alsowant to put aside the hypoth-esis that the Fed is simply following the market,

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Figure 2

Four Possible Scenarios

because I’m convinced from my own observationof the process that this hypothesis is not true.

If the market can predict Fed policy actionsquite consistently, then Fed behavior must besystematic and regular enough that the marketcan make accurate predictions. Thus, the abilityof the market to predict Fed policy actions meansthat the market understands the Fed’s objectivesand the Fed and the markets are reading the flowof incoming information the same way. In thissituation, Fed policy adjustments will not takemarkets by surprise.

Now look at Figure 3. This figure provides amore detailed examination of trading in the June2000 fed funds futures contract from the initialtrade on January 24, 2000, to maturity on June 30,2000. The figure also includes the history of thefed funds target, which stood at 5½ percent onJanuary 24; the FOMC raised the target to 5¾ per-cent at its first meeting of the year on February 1-2.The FOMC raised the target again, by another 25

basis points, at its meeting on March 21. As wealready saw in Figure 1, the final, 50-basis-pointincrease came on May 16.

The opening price of the contract on January 24implied a June fed funds rate of 6.14 percent.Private forecasters were expecting some slowingin the economy. For example, the January BlueChip consensus forecast was for 3.0 percent realgross domestic product (GDP) growth in 2000:Q1and 2.9 percent for the year. The upward trend ininflation that had occurred in 1999 was expectedto continue in 2000. One way to interpret the Junefed funds futures rate of 6.14 percent on January 24is that slightly more than half the market partici-pants thought the Fed’s target rate would be 6¼percent in June while the rest thought it wouldremain at 6 percent. Alternatively, market partici-pants placed a probability a bit above 0.5 thatthe Fed would raise the intended rate by 25 basispoints and a probability a bit below 0.5 that theFed would leave the intended rate unchanged.

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Figure 3

June Contract for Fed Funds and Economic News

Figure 3 includes vertical lines on days whenthere were relatively large changes in the interestrate on the June futures contract. The thresholdI’ve used for defining a “relatively large” changewas ±5 basis points. During the life of this con-tract, there were 8 days on which the absolutechange was 5 basis points or larger. These daysare sorted into four episodes.

The first episode included a Friday and aMonday, January 28 and 31. On Friday, January28, the fed funds futures rate rose 9 basis points.On that day, the 1999 fourth quarter GDP datawere released showing that real GDP had grown5.8 percent at an annual rate, well above marketexpectations. The January Blue Chip consensus,for example, had been 4.5 percent. Inflation alsocame in higher than expected—2.0 versus 1.6percent at an annual rate. On Monday, the stockmarkets rose sharply and the fed funds futuresrate rose another 5 basis points as markets digestedthe unexpectedly good news about economicgrowth and the effect that it was having on fore-casts for future interest rates. After receiving thisinformation, the market expected the fed fundstarget rate to average 6.25 percent in June.

The second episode included a rise and thena decline surrounding Fed Chairman AlanGreenspan’s congressional testimony about mone-tary policy. The first day of his testimony was onFebruary 17. That day the fed funds futures ratefor June rose 6 basis points to 6.27 percent. Thenext day, theWall Street Journal reported,“Greenspan signaled that the Fed will keep boost-ing rates unless both consumer spending and thestock market quickly cool down.”

On February 22, the fed funds futures ratefell 6 basis points. There were no significant eco-nomic data released, and so we cannot link thatdecline to any particular piece of new informa-tion. On February 24, the fed funds futures ratefell another 5 basis points after the governmentreported that orders for durable goods fell 1.3percent in January, suggesting that the economymight be slowing a bit.

The FOMC did raise the fed funds target to 6percent on March 21; from examining the Aprilfed funds futures contract, we know that this

increase was well anticipated by the market. Ascan be seen in Figure 3, at this point the fed fundsfutures rate for June was 6.24 percent, indicatingthat the market expected another 25 basis pointincrease at the May FOMC meeting.

During the third episode, the fed funds futuresrate fell 10 points on April 4 and then bouncedback up 5 points on April 5. It is not clear whatwas the cause of the initial decline. The stockmarket had been very volatile on the 4th—theDow Jones industrials fell over 500 points earlyin the day and then recovered to finish the daydown only 57. On the 5th, the Dow fell another131 points, but Greenspan gave a speech that leftmarkets believing the Fed would lift the fed fundstarget in May. At the end of this episode, the fedfunds futures rate for June was 6.28.

The final episode occurred on April 27 withthe release of the advance GDP report for the firstquarter. This report showed that real GDP rose ata 5.4 percent rate in the first quarter, with con-sumer spending jumping 8.3 percent, which wasthe largest quarterly increase in more than 17years. Labor costs rose 4.3 percent and consumerprices continued to rise. It is interesting to notethat the news was exceptional in one way: Themarket was surprised by both higher than expectedreal growth and higher than expected inflation.Since 1994, there had beenmany upside surprisesabout real GDP growth, but they had typicallybeen accompanied by lower than expected infla-tion. The Wall Street Journal reported that, “Theinflation news boosts the odds that the Fed willsoon raise interest rates by an aggressive half apercentage point.” The fed funds futures marketseemed to agree as the rate rose by 11 basis pointson that day to close at 6.41. The rate then rosegradually to 6.49 on the Friday before the May 16meeting.

I’ve recounted the story of the June 2000 fedfunds futures contract in some detail to illustratea general point. How can the market participantssuccessfully predict what the FOMC will do atits next meeting? That is, how do they know theinterpretation the FOMC will place on the flowof incoming information, such as that recounted

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in the history of the June futures contract? Partof the answer is that market participants carefullyfollow speeches by FOMC members, especiallythose by the chairman, Alan Greenspan. Thetrack record of FOMC actions is also obviouslyimportant. Understanding how the FOMC hasreacted to information in the past aids in predict-ing how the Committee will respond to similarinformation in the future.

Market participants pull together other typesof information as well. They receive the minutesof the FOMC meetings with a six or seven weeksdelay, a few days after the next scheduledmeeting.These minutes reveal the topics discussed, sum-marize views about the state of the economy anddescribe the reasons for dissenting votes. Theminutes are thorough, which provides an impor-tant vehicle for keeping the markets and thepublic well informed about Fed thinking.

Markets have been able to forecast Fed policyactions partly because the policy process is becom-ing more transparent than it was in the past.Since February 1994, the FOMC has announcedchanges in the fed funds target the same day thatthe decisions were made. As recently as the late1980s, the Federal Reserve was still using a com-plex signaling method of conducting open marketoperations (buying and selling securities) to informmarkets about changes in the fed funds rate target.This complex method sometimes took severaldays to transfer information about policy changes.Occasionally, the signals were crossed and mar-kets perceived changes when there were none.Not only was the process inefficient, but also ittended to favor the bond market dealers who hada special arrangement to participate in the execu-tion of openmarket operations. Announcing targetchanges the day they are made makes knowledgeabout policy changes immediately known to all.

Another important feature of post-1994 Fedpractice is that almost all policy actions came atregularly scheduled meetings of the FOMC. Before1994, the Fed changed the intended rate moreoften between regular meetings than at regularmeetings. Clearly, before 1994, the market wasalmost always taken by surprise by Fed policy

actions because the timing of the policy decisionsbetween scheduled FOMC meetings could notbe predicted.

CONFIDENCE IN THE CENTRALBANK

A principal responsibility of the monetaryauthorities in every country is to maintain thepurchasing power of the country’s currency.Monetary responsibilities are split between thefinance ministry (or treasury) and the centralbank. The finance ministry manages governmentfinance, including tax collection, and the centralbank manages the creation of money. In mostcountries today, the central bank has a substantialdegree of independence from the government,and has assigned to it the goal of maintaining thepurchasing power of money. Independence seemsto be the best way to achieve control over moneycreation as necessary to assure stability in thepurchasing power of money.

With a fiat money system, the current valueof the dollar depends on current policy and expec-tations about all future policies. Confidence inthe central bank is a foundation for confidence infinancial markets. Modern economies thrive onthe extension of credit to people who are youngand people who have good ideas. U.S. prosperityin the 1990s, extending to this day, has beendriven by new high-tech enterprises and theapplication of new technology to existing enter-prises. The new enterprises have been financedthrough private venture capital and the publiccapital markets. These firms would not havebeen able to raise such a large amount of capitalif lenders had feared that their principal wouldbe confiscated through inflation.

In the United States, and elsewhere, appreci-ation of the importance of price stability grewsignificantly as people saw the real effects of infla-tionary policies in the 1960s and 1970s. Thischange in beliefs simultaneously increased pres-sure on the Federal Reserve to achieve sustainedlow inflation and increased the determination ofpolicymakers to achieve that goal.

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Figure 4 shows the CPI inflation rate and theexpected inflation rate according to the Michigansurvey from 1956 to the present. The data arequarterly, and the inflation rate shown is the per-centage change in the CPI over the same quarterthe previous year. The expected inflation rate isthe rate respondents said they expected over thenext year.

The actual inflation rate rose almost everyyear from 1965 to 1980. In retrospect, trouble wasalready brewing in 1964. Although the actualinflation rate in 1964 over the correspondingquarter of 1963 was in the 1 to 2 percent range,survey respondents expected the inflation rate torise, as can be seen by the fact that the expectedrate in Figure 4 lies above the actual rate in 1964.The actual rate did rise after 1964, and from thatpoint through the early 1980s the actual andexpected rates moved very much together.

Expected inflation led actual inflation downin 1982, and after 1983 expected inflation wassomewhat more stable than actual inflation. Themarket understood that some of the fluctuationsin actual inflation were transitory, and did notjustify changing views on likely future inflation.The collapse in oil prices in 1986 reduced actualinflation for a time, but had little effect on expectedinflation. Similarly, fluctuations in oil prices in

1998-2000 first brought down and then increasedmeasured inflation without having much effecton expected inflation.

One-year ahead inflation expectations areinadequate to fully explore the issue of marketconfidence in monetary policy, but are the onlysurvey evidence available back to the 1950s. TheMichigan survey started to ask about 5-10 yearinflation expectations in 1979, and those dataare shown in Figure 5. As an aside, judging fromthe behavior of long-term interest rates, marketparticipants initially viewed the inflation of thelate 1960s and early 1970s as temporary, but bythe late 1970s long-term inflation expectationsrose dramatically. Confidence in U.S. price sta-bility really did erode significantly after 1976.However, as policy succeeded in lowering andstabilizing inflation after 1980, long-term inflationexpectations fell and now have reached the lowestlevels observed since the early 1960s.

Low inflation forecasts over long horizonsreflect confidence that the Fed will be successfulin adjusting interest rates in timely fashion asrequired to yield low inflation on the average.With low inflation on average, the federal fundstarget will on average remain relatively lowbecause there will be no inflation premium bidinto interest rates. The Fed can directly control

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Figure 4

CPI Inflation and Short-Term Inflation Expectations

only the overnight interest rate. Thus, a relativelylow 25-year bond rate reflects confidence thatthe Fed will keep inflation under control. Thatconfidence springs from the market’s understand-ing of what the Fed will do with the one-day rate,on average, over the next 25 years. People inmarkets understand very well that it may be nec-essary to raise the fed funds rate aggressively inthe short-term, to ensure that it remains low overthe long-term.

SHORT-RUN POLICY ANDLONG-RUN CONFIDENCE

As already emphasized, the Federal Reserveimplements policy through open market opera-tions designed to keep the overnight federal fundsrate close to the target rate set by the FOMC. Evenif the Fed were to implement policy in some otherway, there is nothing to guarantee that futurepolicy will be consistent with sustained lowinflation. At any given time, success in keepinginflation low requires market expectations thatinflation will remain low—the market must haveconfidence that the central bank will do its jobnot just today but in the future as well.

Where does confidence in long-run U.S.price stability come from? Sustained success in

achieving low and stable inflation is obviouslyimportant. So also is the institutional structureof the Federal Reserve System, which insulatesit from day-to-day political pressures. Attitudeswithin the System, the government, and thegeneral public are surely important. Clearly, thesubject is a complex one and beyond the scopeof this lecture.

The element of confidence I’ve concentratedon—one that I believe is insufficiently appreci-ated—is that the better the market understandsthe day-to-day operation of monetary policy, themore confident the market will be that the Fed ison the right course for the long run. Since 1994,the market has quite accurately predicted Fedpolicy actions, indicating that the market under-stands what the Fed is doing. The market and theFed study incoming data and, more generally,information of all sorts and arrive at a similarassessment of what the information means forthe appropriate setting of monetary policy.

Confidence in any organization is taintedwhenever some part of its activities comes underquestion. The fact that Federal Reserve policyweek by week is systematic and predictableinspires confidence in the larger issue of Fedpolicy over the long run. I believe that this deeperlong-run confidence has contributed to the dura-

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Figure 5

CPI Inflation and Long-Term Inflation Expectations

bility of the current economic expansion and theincrease in productivity growth that has generatedsuch remarkable growth in GDP over the last fiveyears.

There is a mystery, however. The FOMC doesnot follow a well-specified monetary rule thatcan be written down as an equation or formula.How is it that the market and the Fed can so con-sistently agree on the interpretation of new infor-mation and its significance for policy actions, orlack thereof? I don’t know the answer to thisquestion. Finding the answer may be importantfor carrying into the future the market’s currentsuccess in forecasting Fed policy actions. If wecan formalize what the Fed does, it should bepossible to further improve transparency andaccuracy of communication with the market inthe future. As successful as monetary policy hasbeen in recent years, there is still a major agendafor the Federal Reserve and for scholars of mone-tary policy in assuring that the success continues.

CONCLUDING THOUGHTSOne of my themes tonight has been the accu-

racy with which the market today can forecastFed policy actions. How is the market so success-ful? The market has an excellent understandingof the process by which the Fed reaches its policydecisions. That understanding in turn reflects Fedefforts to bemore transparent andmore systematic.For the most part, the Fed and the market readthe flow of new information the same way. Asinformation arrives, the market changes the proba-bility it assigns to Fed action at its next policy

meeting. That is the same process I go throughmyself, changing my view bit by bit as new infor-mation arrives. At the time of an FOMC meeting,I collate all the information, including the expertFed staff analysis, and settle on a tentative posi-tion going into the meeting. That position is sub-ject to change, depending on the force of thearguments my colleagues make during the courseof the meeting.

The goal of the policy actions is to achievelow and stable inflation for the United Statesover the long run. The Fed can do little that isconstructive about short-run fluctuations in therate of inflation, but is responsible for the long-run outcome. The market understands the policyobjective and therefore can judge what policyactions are required to achieve the goal, giventhe ever-changing economic environment. In theresearch that Rasche and I have conducted, mostlarge changes in rates in the fed funds futuresmarket make good sense given the nature of thenew information that apparently drives thesechanges.

This convergence of Fed and market opinionabout what needs to be done is a relatively newdevelopment. Although the convergence is stillsomewhat incomplete, its importance for a suc-cessful monetary policy should not be underes-timated. I myself continue to work to betterunderstand how the Fed might further improveits communication with the markets. The task isnot as easy as it might seem, given the complexityof the economics and the short-run focus of manymarket participants and press representatives.But that is a subject for another day.

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