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FRBSF

WEEKLY LETTER

Number 95-23, June 23, 1995

Federal Reserve Policy and
the Predictability of Interest Rates
On February 4, 1994, the Fed raised its intended
level for the overnight federal funds rate by a
quarter of a percentage point. Immediately following this policy action, one-month interest
rates and other short-term rates rose as well.
Most economists would interpret these market
rate reactions in the context of the "Rational Expectations Theory" of the term structure of interest rates. This theory states that longer-term
interest rates are set according to market expectations of future shorter-term rates: For example,
as a first approximation, the current one-month
interest rate should equal the average of the current overnight rate and the market's expectation
of the next 29 days of overnight rates. According
to this theory, the market rate movements after
the Fed policy action reflected both the immediate change in the overnight rate as well as market expectations about future policy actions that
would affect the overnight rate.

Specifically, spreads between money market rates,
like the three-month bill rate, and the overnight
rate appear to have predictive information about
future changes in the overnight rate. In addition,
spreads between very-short-term monthly bill
rates seem to have predictive information about
future changes in short rates at horizons of less
than two months. For example, the spread between one-month and two-month Treasury bill
rates is able to predict some future changes in
the one-month rate. However, yield spreads in"
volving bills with maturities between three and
twelve months have essentially no predictive information for future changes in these rates. For
example, with postwar data, many researchers
have found essentially no information in the
spread between yields on three-month and
six-month Treasury bills for forecasting future
changes in the three-month rate.

Federal Reserve interest rate targeting
Thus, to understand the term structure of interest
rates, it is necessary to understand how the Fed
conducts policy, in terms of the goals and strategies that the Fed pursues, as well as the tactics
by which it operates to affect the overnight funds
rate. This Letter examines the tactics of monetary
policy in order to shed some light on the behavior of the short-end of the yield curve. This Letter
also describes some possible explanations for the
choice of these particular operational tactics. (For
a recent discussion of the goals of monetary policy, see Judd and Trehan 1995.)

Predictability of short-term interest rates
This Letter focuses on the ability of spreads between short-term interest rates of various maturities to predict future interest rate movements.
One implication of the Rational Expectations
Theory of the term structure is that the spread
between longer-term and shorter-term rates
should be able to forecast future changes in the
shorter-term rate. However, many researchers
have empirically tested this implication and have
obtained disparate results: Term spreadsappear
to be able to predict future changes in.interest'
rates of only certain maturities.

111 Rudebusch (1995), I explain the disparate
evidence on the predictability of short-term interest rates with an explicit econometric model
of the Fed's day-to-day operating procedures,
which, over much of the past two decades,
can be roughly construed as targeting interest
rates. In essence, my argument is that the way in
which the Fed targets interest rates, for example,
its "smoothing" of rates, implies the predicta~
bilityof interest rate movements only at certain
horizons.
The Fed's interest rate targeting behavior can
be broadly summarized with three attributes.
First, the Fed does not peg the market funds
rate to the target rate on a daily basis. Indeed,
because the Fed typically oniyenters the market
to influence the spot rate once each day, large
deviations of the market rate from the target
rate are allowed. This is apparent in Figure 1,
which provides an illustrative sample of daily
data from the mid-70s on the target federal funds
rate (solid line) as well as the actual market rate
(dashed line). The average daily deviation is a
couple tenths of a percentage point; however,
any given day's deviation from the target rate is

FRBSF
Figure 1
Federal Funds Rate

target rate will change again in the same direction than in a different direction; however, after
a month or two have passed, the likelihood of a
change in the same direction is not greater than
the likelihood of a change in a different direction.
That is, beyond a horizon of one or two months,
there are no movements planned in the future to
react to information already known.

Percent

7.5
7.0

Fed behavior and interest rate predictability

6.5
6.0

5.5
5.0
4.5

02

03

1976

04

01

02

03

04

01

1977

largely eliminated by the following day. Thus, although the funds rate is not pegged to the target
each day, the Fed does appear to enforce the target over the course of a few days.
Second, the Fed engages in short-term interest
rate "smoothing"-that is, the target level of the
federal funds rate is not adjusted continuously
but in limited amounts at a restrained, deliberate
pace. As a broad characterization, target changes
are conducted in small, standardized steps, very
often only one-quarter or one-half of a percentage point in size. In addition, target changes
are seldom immediately reversed; for example,
an increase in the target rate is usually not followed very soon after by a decrease. Thus, a
typical policy action is implemented with gradual increases or decreases (but not both) in the
target rate. This attribute is reflected in the "stepfunction" aooearance of the target rate in the figure, where a'series of closely-spaced, small target
changes are made in the same direction.
Third, there is a persistence to the target level.
Abstracting from the short-term interest rate
smoothing considerations, the target rate is generally set at a level the Fed expects to maintain.
The interest smoothing considerations suggest
that during the first several weeks after a target
change there is a higher probability that the

The three attributes of the Fed's interest rate
targeting behavior appear to be able to account
for the various term structure results described
above. For example, the fact that the spread between short-term money market rates and the
federal funds rate predicts future movements in
the funds rate can be explained, at least in part,
by the transitory daily deviations from the persistent target rate. !ftoday's funds rate is unusually
high relative to the target, it can be expected that
tomorrow's funds rate (and future daily rates) will
return to the target level; thus, the current threemonth rate, which is an average of those future
daily rates, will remain close to the target funds
rate. In this way, the spread between the overnight funds rate and the three-month rate is a
good predictor of the change from the current
daily rate to the average daily rate that prevails
over the next three months.
The other predictive information that is available
at the very short end of the term structurefor example, the ability of the one-month and
two-month rate spread to predict future short
rates-likely reflects the gradual nature of policy actions. Suppose that a major piece of information arrives that clearly requires a large target
change; following its interest rate smoothing precepts, the Fed accomplishes this change with a
sequence of gradual target adjustments. The gap
in timing between the release of the new information and the completion of the policy action
will generate predictable changes in interest
rates at very short horizons, which will be incorporated into yield spreads.
Finally, the evidence for the absence of predictive
information in the three- to twelve-month range
of the term structure can likely be associated
with the third attribute of Fed behavior, namely,
target persistence. If market participants (rationally) expect the Fed to maintain the current
funds rate target, then term spreads between
various interest rates will not be able to predict
future changes in interest rates. In essence, the
term spreads have no predictive information

because there is none available for them to in~
corporate: Beyond a couple of months, future
policy actions are unpredictable.

The rationale for Fed behavior
In light of this analysis, the question arises as to
why the Fed has conducted policy in this manner. Some speculations are offered below.
The reason for allowing daily transitory deviations from the target rate may simply be that any
benefit from eliminating such volatility for the
conduct of monetary policy is modest, especially
relative to the cost of having to enforce targets
more closely. In addition, useful operational information about demand and supply in the market for reserves may be obtained by allowing
transitory daily deviations from the target to
develop.
The short-run smoothing of interest rates evident in the gradual target adjustments of limited
size in a single direction may be of much greater
import. The Federal Reserve, as well as the financial press, appears to interpret the purpose of
such smoothing to be the avoidance of "undue
stress" on financial markets; thus, the increases
in short-term rates in early 1994 were "measured
and deliberate" so as not to unsettle financial markets. Besides gradual adjustments, interest rate
smoothing also discourages quick reversals of
the direction of target changes. Such reversals
are thought to "whipsaw" the market and also
contribute to disorder.

A similar rationale of stabilizing or steadying
markets also could be given for the persistence
of the target rate. However, there is a niore subtle
reason why the Fed might impart a persistent (or
random-walk) behavior to the Fed funds rate.
Clearly, output and prices do not respond to
daily fluctuations in the overnight funds rate but
only to rates of, at the very least, several months
maturity. Thus, for the Fed to attain its macroeconomic goals, it must be able to manipulate
these longer-term rates. However, such rates are
determined by market expectations of future
funds rates; thus, by presenting the markets with
a clear path for the future funds rate, the Fed can
influence the longer-term rates. A constant funds
rate is the path that likely communicates policy
intentions most clearly and perhaps most credibly to markets. Thus, the pursuit of macroeconomic stabilization may impart a high degree of
persistence to the funds rate.

Glenn Rudebusch
Research Officer
References
Judd, John P. and Bharat Trehan. 1995. "Has the Fed
Gotten Tougher on Inflation?" FRBSF Weekly Letter
(March 31).
Rudebusch, Glenn D. 1995. "Federal Reserve Interest
Rate Targeting, Rational Expectations, and the Term
Structure:' Journal of Monetary Economics (April)
pp.245-274.

.opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal·Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System. Editorial comments may be addressed to the editor
or to the author. Free copies of Federal Reserve publications can be obtained from the Public Information Department, Federal
Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246, Fax (415) 974-3341. Weekly Letter
texts and other FRBSF publications and data are available on FedWest Online, a public bulletin board service reached by setting
your modem to dial (415) 896-0272.

Research Department

Federal Reserve
Bank of
San·Francisco
P.O. Box 7702
San Francisco, CA 94120

Printed on recycled paper
with soybean Inks..

IC>t. ~
W ~

Index to Recent Issues of FRBSF Weekly Letter

DATE

NUMBER TITLE

AUTHOR

12/30

94-44
95-01
95-02
95-03
95-04
95-05
95-06
95-07
95-08
95-09
95-10
95-11
95-12
95-13
95-14
95-15

Spiegel
Trehan
Parry
Levonian
FurionglZi mmerman
Rudebusch
Hutchison
MatteylDean
LevonianlFuriong
Spiegel
Moreno
Mattey
Dean
JuddlTrehan
GlicklMoreno
Huh
Parry
Laderman
GlicklTrehan
Judd
Kwan
SchaanlCogley
Kasa

116
1/13
1/20
1/27
2/3
2/10
2/17
2/24
3/3
3/10
3/17
3/24
3/31
4/7
4/14
4/21
4/28

SIS
5/12
5/19
5/26
6/9

95-16
95-17
95-18
95-19
95-20
95-21
95-22

Gradualism and Chinese Financial Reforms
The Credibility of Inflation Targets
A Look Back at Monetary Policy in 1994
Why Banking Isn't Declining
Economy Boosts Western Banking in '94
What Are the Lags in Monetary Policy?
Central Bank Credibility and Disinflation in New Zealand
Western Update
Reduced Deposit Insurance Risk
Rules vs. Discretion in New Zealand Monetary Policy
Mexico and the Peso
Regional Effects of the Peso Devaluation
1995 District Agricultural Outlook
Has the Fed Gotten Tougher on Inflation?
Responses to Capital Inflows in Malaysia and Thailand
Financial Liberalization and Economic Development
Central Bank Independence and inflation
Western Banks and Derivatives
Monetary Policy in a Changing Financial Environment
Inflation Goals and Credibility
The Economics of Merging Commercial and Investment BankirJg
Financial Fragility and the Lender of Last Resort
Understanding Trends in Foreign Exchange Rates

The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.