Would a Fed Rate Hike Surprise Really Matter?

Any change in interest rates will be sprung on the marketsrnif John Williams, Federal Reserve Bank of San Francisco president, gets hisrnway.  While we suspect that any shockrnvalue surrounding this particular event would be moot, Williams told CNBC thisrnweek that “My personal preference is that we don’t have the mostrntelegraphed policy decisions in history, as we did in 2004.”  He added “You don’t want to make arndecision two months or three months in advance.”</p

While it appeared unrelated to William’s remark, Wells FargornBank just released the first in a series of articles which seek to quantify thernexpected reaction of a fed funds rate shock on several different markets. Thernbank cites the example of then Fed chairman Ben Bernanke’s comments in thernsummer of 2013 which caused investors to revise their expectations about the Fedsrnmonetary policy and rates and led to the so-called “taper tantrum”. </p

The first article looks at the concept of a surprise andrndevelops a theory as to why surprises are employed rather than simply makingrnchanges, outlines different measures for measuring surprises, and looks at thernsensitivity of the first of several markets, the dollar exchange rate</p

A surprise component can offset the effect of market expectations.  In theory, as all publicly availablerninformation should be discounted into prices, if macroeconomic news perfectlyrnmatched advanced expectations asset prices would not move.  In practice this may not always be the casernas uncertainty plays a role and because individual market participants may havernacted counter to expectations.  As arncontrol for its study Wells uses the surprise component (the difference of the actualrnrelease from expectations) rather than actual release value.</p

One way of determining the surprise component of a fed fundsrnrate announcement is to determine expectations and compare the actual releasernto it.  The second method is to look at financialrnassets themselves to see how their prices, which should already incorporaternexpectations, change following the announcement then calculate the surprise componentrnfrom the movement. A third method, a statistical proxy for expectations wasrndiscounted completely. </p

Wells’ economists decided that the most appropriaterninstrument for determining expectations regarding a Federal Open MarketrnCommittee (FOMC) policy announcement was the fed funds future contracts whichrnthey said were superior at predicting the funds rate for short time horizons.  They plotted the surprise component extractedrnfrom those contracts for the time period 1994 to 2014, eventually truncatingrnthe data set at the end of 2008.  </p

They partitioned their dataset to study how fed funds raternsurprises affect different markets before and during the crisis, defining thernbeginning of the crisis as the first time the FOMC reduced interest rates for therncycle, at its September 2007 meeting. rnThey then studied the sensitivity of the trade weighted dollar tornsurprises in the rate.  </p

The interest rate differential between two countries is a largerndriver of the exchange rate and they anticipated that unexpected moves in the federalrnfunds rate would also drive moves in the dollar around these announcements.  These changes would, on average be associatedrnwith a strengthening of the dollar.</p

Using an event-study approach they regressed the percentrnchange in the dollar index around surprises on the unexpected component ofrnannouncements in the fed funds target rate. rnAn earlier Chicago Fed study had found that the dollar/mark andrndollar/yen exchange rates were affected by the unexpected component of a fed fundsrnannouncement but the effect was not evident until a large amount of time hadrnpassed, something Wells Fargo’s analysis could not capture from the dailyrnreturns it was using.  “Clearly thernrelationship,” they say, “is more complicated than we initially thought.”</p

Wells Fargo’s findings support the Chicago Fed’s immediaternresults, that is that fed funds surprises have an insignificant effect on therndollar initially.  This was at odds withrnits starting hypothesis that the dollar would strengthen immediately followingrna surprise.  An alternative explanationrncould be the signaling effect that is contained in the unexpected component cancelsrnout, on average, the effect caused by interest rate differentials. </p

It is plausible that news contained in a surprise could causerninvestors to revise their expectations regarding the domestic economy and,rngiven the size of the U.S. economy, could have large implications on the globalrneconomy, which could change investors’ risk preferences. The economists use thernexample of an unexpected rate cut sending a signal the economy is weaker thanrnmany thought, causing a flight to the safety of the dollar.  Investigating the subsamples before and duringrnthe crisis and checking for asymmetric responses to see if the dollar respondedrndifferently to positive versus negative surprises all resulted in finding that thernsensitivity of the dollar was insignificant.</p

In subsequent articles Wells Fargo will look at the effectrnof surprises on other financial assets including Treasury securities and broadrnequity indices in order to gain insight on the behavior of financial marketsrnsurrounding the impending rate announcement and will attempt to quantify thernreaction to surprises, both positive and negative.</p

Incidentally, Williams acknowledged that keeping fed moves close to thernchest could lead to some market swings.  “Inrna normal economy there is some volatility in markets, that is just a healthyrnfunctioning of markets trying to understand and filter what the data means forrnpolicy,” he said. “It’s healthy for the future actions to bernuncertain because economic conditions can change.” </p

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