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July 1995
(Combines July 1 and July 15 issues*)

Federal Reserve Bank of Cleveland

Monetary Policy and the Federal
Funds Futures Market
by John B. Carlson and Jean M. Mclntire
.L/ve rarely unfold exactly as we
foresee them. In the monetary policy
arena, for example, the timing and intensity of specific actions can be difficult to
anticipate. Following a 15-month period
during which no policy action was taken,
the Federal Open Market Committee
(FOMC), the central bank's policymaking arm, embarked on a series of moves
that has raised money market interest
rates seven times since January 1994.
More specifically, FOMC actions lifted
the federal funds rate—the interest rate
banks charge each other for overnight
loans—from 3 percent to 6 percent (see
figure 1). Four of these actions were
accompanied by increases in the discount rate—the rate the Federal Reserve
charges banks that borrow at the discount window. At 514 percent, the discount rate is now 2lA percentage points
above where it stood before the series of
policy moves was initiated.
As the operating target of the FOMC,
the fed funds rate is a benchmark for
overnight lending rates and hence a key
rate against which to hedge or even to
speculate. In 1988, the Chicago Board of
Trade began trading an interest-rate
futures contract based on average
monthly fed funds rates (see box). A 30day fed funds futures contract may be
written for any calendar month up to 24
months ahead. (Contracts for six months
ahead or more are less common.) The
market price of fed funds futures embod-

ies a prediction of the monthly average
of the daily fed funds rate.
Because market participants understand
that deviations of the overnight funds
rate from its desired level will tend to
average out over the span of a month,
the implied rate is essentially the market's expectation of the FOMC's
intended rate.1 Thus, the fed funds contract offers in fairly precise terms a market indicator of expected future policy
actions. In this Economic Commentary,
we review the circumstances that led to
the series of policy actions initiated in
January 1994 and examine how well the
fed funds futures market anticipated the
policy moves. We also assess how the
outlook of the fed funds futures market
has changed dramatically in 1995.

• The Practice of
Monetary Policy
Participants in futures markets have
every incentive to understand the determinants of the price for the commodity
or financial instrument on which the
contract is written. Fed funds futures are
perhaps unique in the sense that the
monthly-average fed funds rate is determined by a deliberative process—a decision of the FOMC. Although the fed
funds rate varies substantially on a daily
basis, its monthly average is generally
close to the intended range that the
FOMC communicates to the New York
Trading Desk.2 Because the level of the
fed funds rate is essentially determined

How well did the federal funds futures
market anticipate recent monetary
policy actions? The authors examine
the predictive content of fed funds
futures rates, which provide the Federal Open Market Committee with a
clear reading of market expectations
for policy, in the context of 1994 policy
moves and analyze the fed funds
futures market outlook in early 1995.

by policy decisions, the fed funds futures
rate would be expected to have predictive value for the size and timing of
future policy actions.
To appreciate the behavior that leads to
changes in interest rates, it is helpful to
understand the context in which U.S.
monetary policy decisions are made.
Ultimately, monetary policy seeks to
achieve the highest possible advance in
Americans' living standards over time.
This goal can best be accomplished if
policy actions do not allow concerns
about the variability of the purchasing
power of money to become a factor in
private decisions. In his February 1995
testimony before Congress, Federal
Reserve Chairman Alan Greenspan
stated, " Price stability enables households and firms to have the greatest
freedom possible to do what they do
best—to produce, invest, and consume

• The Economic Commentary series will contain 20 issues starting this year. The sequence will remain semimonthly EXCEPT during June, July, November, and December, when we will publish a single
issue for the month.


• Policy Actions and the Recent
Run-up in the Fed Funds Rate

After each trading day. The Wall Street
Journal publishes data on outstanding
contracts for 30-day fed funds futures.
The data include the open, the high
and low for the day, and the "settle"
price (around closing), as shown in the
table below. The futures settlement
price is calculated as 100 minus the
monthly arithmetic average of the
daily effective fed funds rate that the
New York Trading Desk reports for
each day of the contract month.

In February and July of each year, the
FOMC sets annual growth ranges for the
monetary and credit aggregates and
makes projections for output growth,
inflation, and the unemployment rate.
Chairman Greenspan presents these
ranges and projections in testimony
before Congress pursuant to the
Humphrey-Hawkins Act of 1978. In the
February 1994 report, the FOMC anticipated reasonably strong output growth,
a slight acceleration in inflation, and a
relatively steady unemployment rate.

Thus, from the settlement price, one
can obtain the implied rate for the
specified contract month. To illustrate,
consider the settle column for the May
contract, which indicates a price of
93.98 and hence an expected fed funds
rate of 6.02 percent. The 93.81 September contract price, on the other
hand, implies an expected rate of 6.19
for that month.
Interest-Rate Futures—
30-Day Federal Funds











Unfortunately, there is no consensus on
the appropriate path to this ultimate goal.
The link between the primary instrument
of monetary policy—the fed funds rate
—and its ultimate goal is complex and
not easy to understand. Monetary policymaking is thus an uncertain enterprise in
which FOMC members must make their
best judgments about the level of shortterm interest rates consistent with the
specified goals. Policy moves—changes
in the fed funds rate—are generally
made incrementally, as new information
about the effects of previous actions
becomes available and in the context of
other events that may bear on the future
path of economic activity.

Although the economy had been
expanding on average since the spring of
1991, recovery from the 1990-91 recession had been unusually fragile. Economic and financial restructuring was
thought to have restrained output from
growing at a more normal pace. Moreover, inflation fell to rates not seen since
the early 1960s. Over this period, monetary policy maintained an increasingly
accommodative stance in reserve markets. Reserve conditions were associated
with a fed funds rate that fell to around 3
percent—at or near the trend inflation
rate. This implied a real yield of near
zero. Long-term interest rates, although
somewhat higher, continued to fall until
October 1993 (see figure 2).
By the end of that year, however, forecasters believed that the strong economy
had gained substantial momentum that
would carry on into 1994. What's more,
inflationary pressures were thought to be
building. It was against this backdrop
and with a desire to extend the gains
associated with low and declining inflation that the FOMC embarked on the
series of policy actions that raised both
the fed funds rate and the discount rate.
Although the fed funds futures market
anticipated a rise in the fed funds rate in
early 1994, the frequency and cumulative
magnitude of policy actions appeared to
surprise most market participants. Figure
3 contrasts the actual path of the effective
fed funds rate with the rate path implied
by reported futures prices on three days
throughout the year. For example, on the
first trading day of the year (January 3,
1994), market prices indicated an expec-

tation that the fed funds rate would rise to
around 3lA percent in June. In fact, the
actual rate rose to 3'/2 percent in April
and to AVA percent in June.
By midyear, the fed funds futures market
seemed to get on track in its prediction of
future funds rate changes. The implied
futures rates on July 20 proved to be
accurate predictors of the actual policy
path. At year's end, however, futures
rates anticipated a continuation of rate
increases that has yet to materialize.
The 1994 experience with fed funds
futures as a predictor of future rates
accords with the longer—though relatively short—history of the instrument.
The tendency is for predictions to be
more accurate, the shorter the horizon.
This to some extent reflects the incremental nature of policymaking.
No individual policy action is likely to
have decisive or even identifiable economic effects. Rather, the cumulative
effect of a series of policy actions can be
substantial. As a result, policy actions
tend to be persistent: Interest-rate
increases tend to be followed by additional increases and, after a turning
point, decreases by additional decreases.
As one might expect, the predictive
accuracy of fed funds futures is lowest
just before one of these policy turning
points. However, once policy changes
direction, it becomes easier to predict,
especially over longer horizons.


Policy Expectations for 1995

After steadily rising since fall 1993,
yields on government bonds and notes
have declined noticeably since November 1994. The turnaround in these rates
has been associated with evidence that
economic growth is slowing to a more
sustainable pace. Moreover, the inflationary pressures identified early last year
have yet to become manifest in a rise in
trend inflation. Under these circumstances, the FOMC has increased the fed
funds rate only once since November
1994. This leaves the actual fed funds
rate well below the path implied by fed
funds futures at year's end.

During May, fed funds futures rates
moved below 6 percent (see figure 4),
suggesting that market participants
started to anticipate that the next policy
move has tilted toward an easing. This
sea change in expectations began in
February and seemed to be reinforced
by Chairman Greenspan's testimony
before Congress on February 22, when
he suggested that the accumulation of
policy actions may have been sufficient
to head off inflationary pressures. Moreover, the futures rate change has been
accompanied by a pronounced decline
in long-term interest rates, which
peaked in November 1994—more than
a percentage point above current levels.







SOURCES: Board of Governors of the Federal Reserve System; and Federal Reserve Bank of New York.







It is interesting to note that a leveling of
the fed funds rate for a sustained period
is not necessarily associated with a turning point. For example, from late
December 1989 to late July 1990, the
funds rate remained close to 8.25 percent, its intended rate. This episode was,
in retrospect, only a temporary cessation
from a longer-term decline. As current
events unfold, the FOMC may find
increasing evidence that would induce it
to move in either direction. Such events,
by their nature, are difficult to foresee.


SOURCE: Board of Governors of the Federal Reserve System.


















SOURCES: Board of Governors of the Federal Reserve System; and Chicago Board of Trade.

7.00 •


Although peaks in the fed funds rate are
often associated with subsequent peaks
in the business cycle, this is not always
the case. From May 1983 to August
1984, the fed funds rate rose 300 basis
points, exceeding HVi percent, largely in
response to fears that inflationary pressures were rebuilding. When inflation
failed to materialize, rates fell to about
IVi percent in June 1985 and peaked
again six months later at about 8'4 percent. Should the recently observed price
pressures abate for a sustained period,
we may see a series of fed funds rate

February 1,1995

February 28,1995
May 19,1995

June 7,1995


SOURCE: Chicago Board of Trade.


Months ahead



Fed funds futures rates provide the
FOMC with a clear reading of what the
market expects it to do over horizons of
several months. The predictive content
of these rates is quite reasonable, particularly over shorter horizons. The limited
history of this instrument suggests, on
the other hand, that predictive accuracy
is lowest around policy cycle turning

points. As with predicting turnarounds in


business cycles, timing is paramount.

1. In recent months, the FOMC has announced immediately after policy deliberations any actions taken to change the
intended rate.

Thus, it should not be surprising that the
fed funds futures market did not fully
anticipate the policy shift in early 1994.
In the first five months of 1995, the fed
funds rate increased only once and by less
than had been anticipated. Over this
period, fed funds futures rates revealed a
growing belief that the policy cycle has
peaked. How rates proceed from this
point depends largely on the progress
made toward heading off inflationary
pressures before they become embedded
in the inflation trend. What seems certain
now is that no one can really know
whether the cumulative effect of policy
actions has been sufficient.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
Address Correction Requested:
Please send corrected mailing label to
the above address.
Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.


2. From October 1988 (when fed funds
futures contracts were first traded) through
1994, the average deviation between the
actual and intended fed funds rate was only
0.03 percentage point (or 3 basis points). The
mean absolute deviation was 6 basis points.
For a more thorough discussion of fed funds
rate determination, see John B. Carlson, Jean
M. Mclntire, and James B. Thomson, "Federal Funds Futures as an Indicator of Future
Monetary Policy: A Primer," Federal Reserve Bank of Cleveland, Economic Review,
vol. 31, no. 1 (1995 Quarter 1), pp. 20-30.
3. As specified in the Federal Reserve Act,
the central bank is charged with promoting,
over time, maximum employment, stable
prices, and moderate long-term interest rates.

4. Since their inception, fed funds futures
have tended to overpredict the fed funds rate
at all horizons (see Carlson, Mclntire, and
- Thomson, footnote 2). This suggests that fed
funds futures pricing may be dominated by
consistent borrowers of overnight funds who
are willing to pay a premium to hedge
against the risk of rising interest rates.

John B. Carlson is an economist and Jean M.
Mclntire is a senior research assistant at the
Federal Reserve Bank of Cleveland. The
authors thank William P. Osterberg for helpful comments.
The views stated herein are those of the
authors and not necessarily those of the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve

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