Effects of Fed policy rate forecasts on real yields and inflation expectations at the zero lower bound

Focus

Long-term real interest rates play an important part in the transmission of monetary policy measures to aggregate demand. But there are concerns that the unconventional monetary policy tool of forward guidance may not be effective when policy rates fall to zero, ie reach their zero lower bound (ZLB). A further concern is that the publication of policy rate forecasts at the ZLB may be perceived as an unconditional commitment, thus undermining the credibility of monetary policy. We investigate both these concerns for the policy rate forecasts made by the Federal Reserve in its Summary of Economic Projections (SEP).

Contribution

We study how surprises in the Fed's SEP policy rate forecasts made at the ZLB affect real yields and breakeven inflation rates across the yield curve. We use forward rates with horizons from two to 10 years ahead derived from nominal and index-linked US government bonds.

Findings

We find that surprises in the SEP policy rate forecasts significantly affect real yields in the expected direction across the yield curve. By contrast, breakeven inflation rates are little affected, including five-year breakeven inflation rates five years ahead, a common measure of monetary policy credibility. This suggests that policy rate forecasts by the Fed at the ZLB managed to affect real yields without adversely affecting monetary policy credibility.

Abstract

We study the effects of quantitative policy rate forecasts by the Federal Reserve on real yields and inflation expectations at the zero lower bound (ZLB). We study the effects of surprises in policy rate forecasts from the Summary of Economic Projections (SEP) on real yields and breakeven inflation rates derived from government bonds for forward rates across the yield curve. We find that surprises in the SEP policy rate forecasts significantly affect real yields in the expected direction across the yield curve. By contrast, breakeven inflation rates are little affected across the yield curve. In particular, five-year breakeven inflation rates five years ahead, a common measure of monetary policy credibility, are not significantly affected by surprises in SEP policy rate forecasts. This suggests that policy rate forecasts by the Fed at the ZLB managed to affect real yields without adversely affecting monetary policy credibility.

JEL classification: E52, E58

Keywords: forward guidance, policy rate forecasts, zero lower bound