CENTRAL BANK TRANSPARENCY AND SHORT TERM INTEREST RATE FORECASTING UNCERTAINTY Marc Hayford and A.G. Malliaris Loyola University Chicago Prepared for the IBEFA/ASSA MEETINGS January 3 – 5, 2009 San Francisco, CA

Introduction Past 10 – 15 years central banks have moved to a more transparent monetary policy (Carpenter 2004) Types of monetary policy transparency: goal transparency explicit inflation targets (20 countries) Fed’s “dual mandate” instrument transparency explicit targets for short term interest rates more information on bias or tilt of future monetary policy implementation transparency

Empirical literature on Monetary Policy transparency (MRT): Development of indexes of MP transparency Regress various measures of economic and financial activity on transparency index Results: Demertzis and Hallet (2002): ↑MPT → ↓ variance of inflation but not mean inflation Cortareas et al (2003): ↑MPT → ↓ mean inflation but not variance Ehrmann and Fratzcher (2007) ↑MPT of Fed → more predictable MP Crowe and Meade (2007) ↑MPT → increase use of public information by private forecasters Swanson (2004) ↑MPT of Fed → U.S. forecasters and financial markets have become better at forecasting short-term interest rates. Our research is similar to Swanson (2004) however use a different data set and regression model.

Evolution of U.S. monetary policy towards more transparency: In a series of steps since February 1994 the FED has revealed more information and revealed the information sooner about monetary policy. Prior to February 1994 market participants had to guess the Fed funds target: Minutes released with a lag of at least 30 days after the meeting. From FOMC minutes December 1993, released 30 days after the meeting: “In the implementation of policy for the immediate future, the Committee seeks to maintain the existing degree of pressure on reserve positions. In the context of the Committee's long-run objectives for price stability and sustainable economic growth, and giving careful consideration to economic, financial, and monetary developments, slightly greater reserve restraint or slightly lesser reserve restraint might be acceptable in the inter-meeting period. The contemplated reserve conditions are expected to be consistent with moderate growth in M2 and M3 over coming months.”

Beginning February 1994: post FOMC meeting press releases signaled changes in Fed funds but not explicit target FOMC Press Date: February 4, 1994 For immediate release Chairman Alan Greenspan announced today that the Federal Open Market Committee decided to increase slightly the degree of pressure on reserve positions. The action is expected to be associated with a small increase in short- term money market interest rates. The decision was taken to move toward a less accommodative stance in monetary policy in order to sustain and enhance the economic expansion. Chairman Greenspan decided to announce this action immediately so as to avoid any misunderstanding of the Committee's purposes, given the fact that this is the first firming of reserve market conditions by the Committee since early 1989.

Beginning July 1995: post FOMC meeting press releases explicitly state the Fed funds target Release Date: July 6, 1995 For immediate release Chairman Alan Greenspan announced today that the Federal Open Market Committee decided to decrease slightly the degree of pressure on bank reserve positions. As a result of the monetary tightening initiated in early 1994, inflationary pressures have receded enough to accommodate a modest adjustment in monetary conditions. Today's action will be reflected in a 25 basis point decline in the federal funds rate from about 6 percent to about 5-3/4 percent.

May 1999: post FOMC meeting press releases reasoning for target level as well as expected future path of Fed funds target Release Date: May 18, 1999 For immediate release The Federal Reserve released the following statement after today's Federal Open Market Committee meeting: While the FOMC did not take action today to alter the stance of monetary policy [FFR = 4.75%], the Committee was concerned about the potential for a buildup of inflationary imbalances that could undermine the favorable performance of the economy and therefore adopted a directive that is tilted toward the possibility of a firming in the stance of monetary policy. Trend increases in costs and core prices have generally remained quite subdued. But domestic financial markets have recovered and foreign economic prospects have improved since the easing of monetary policy last fall. Against the background of already-tight domestic labor markets and ongoing strength in demand in excess of productivity gains, the Committee recognizes the need to be alert to developments over coming months that might indicate that financial conditions may no longer be consistent with containing inflation.

Fed’s intention: Bernanke (2007): Claim: increased instrument transparency, i.e. explicit Fed funds target + information about the bias or tilt of future monetary policy → ↑ effectiveness of monetary policy Argument: Fed only controls a short-term interest rate – Fed funds rate Spending depending on long term interest rates Expectations approach to the term structure of interest rates → long term interest rates = average of expected current and future short term interest rates Increased MP transparency about current and future Fed funds rate → alignment of market expectations with future monetary policy → monetary policy more effective in moving long term interest rates and thus more effective in influencing economic activity and maintaining stable inflation.

Empirical question: Has increased transparency about US monetary policy reduced the uncertainty market participants have about future monetary policy? Attempt at an answer: Use forecasts of future 3-month T-bill rates from the Survey of Professional Forecasters (SPF) as proxy for future expected Fed funds rate - 3-mth T-bill rates closely tracks Fed funds rate - Dispersion of future 3 mth T-bill rate forecasts can be used as a measure of uncertainty about the future monetary policy - Ex post forecast errors can also be used as a measure of uncertainty about the future monetary policy

Analysis of spikes in forecast dispersions in excess of one standard deviation reveal: In 91 quarters from 1984:1 to 2008:3 there are 35 “spikes” i.e. quarters of forecast dispersion in excess of at least one standard deviation. Spikes correspond to: financial crises absolute size of the change in Fed funds rate

Basic regression model Transparency dummies: D k = 0 and then beginning in k = 94:1 95:4 99:3 D k = 1 Financial crises dummies: 87CRASH = 1 for 1987:4 and 0 otherwise AISAN = 1 for 1997:3 and 0 otherwise RUSSIAN = 1 for 1998:4 and 0 otherwise NINE11 = 1 for 2001:4 and 0 otherwise Hypothesis: Β 2 and β 3 < 0 if transparency has reduced uncertainty

Conclusions: Regression results suggest that: 1) The 1994 and 1995 change in monetary policy transparency had the biggest impact of the level of forecast dispersions: The standard deviation of forecasts decreased (relative to their sample means) by about: -30% to -50% for the 1 quarter ahead T bill forecasts -20% to -30% for the 2 quarter ahead T bill forecasts -20% for the 3 quarter ahead T bill forecasts 2) The range of the decrease in forecast dispersions is similar for the 4 and 5 quarter ahead forecast dispersions, although the estimates are not statistically significant. 3) The responsiveness of forecast dispersions to changes in the Federal funds rate decreases due to increased transparency but the coefficients are not precisely estimated. 4) Controlling for financial crises, the ex post T-bill forecast errors have decreased over time as monetary policy has become more transparent. In sum: Controlling for financial/political crisis and the absolute value of the change in the Federal funds rate, the changes in monetary policy transparency introduced in 1994 and resulted in a large reduction in T-bill forecast dispersions and in our interpretation uncertainty about future monetary policy, 1 to 3 quarters into the future.