Monetary policy expectation errors

BIS Working Papers  |  No 996  | 
27 January 2022
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 |  83 pages



How market participants form expectations about future monetary policy is crucial to macroeconomics and finance. To investigate how financial markets price the outlook for monetary policy, we study the information about future monetary policy embedded in money market derivatives instruments such as fed funds (FF) futures and overnight index swaps (OIS). We find novel insights into how expectations about future monetary policy are formed, and we shed light on when and how market expectations diverge from subsequent central bank actions.


We challenge the mainstream view that term premia drive excess returns on fed funds futures and OIS contracts. Instead, we highlight the role of expectation errors as being the main source of excess returns. We discover that, at least in normal times, fed funds futures and OIS are more reliable gauges of monetary policy expectations than previously appreciated. This finding rehabilitates the expectations hypothesis for short maturities. Finally, we study an international sample of several major central banks, which confirms our main findings.


We find that seemingly biased expectations and positive excess returns on Fed funds futures and OIS stem from market participants underestimating the size of the Fed's interest rate cuts in response to infrequent but large, negative shocks. These episodes are characterised by low stock returns and high uncertainty about the future course of monetary policy. Consequently, we show that falling stock returns predict subsequent excess returns on money market instruments. Higher stock prices by contrast do not predict rate hikes and subsequent low excess returns on money market instruments. The most plausible interpretation is that excess returns on fed funds futures and OIS stem from investors having underestimated by how much the central bank would ease in response to rare shocks accompanied by deteriorating financial conditions.  


How are financial markets pricing the monetary policy outlook? We use survey expectations to decompose excess returns on money market instruments into term premia and expectation errors. We find excess returns to be driven primarily by expectation errors, whereas term premia are negligible. Our findings point to challenges faced by investors in learning about the Federal Reserve's response to large, but infrequent, negative shocks in real-time. Rather than reflecting risk compensation, excess returns stem from investors underestimating by how much the central bank has eased in response to such rare shocks. We document similar results in an international sample.

JEL classification: E43, E44, G12, G15.

Keywords: expectation formation, monetary policy, federal funds futures, overnight index swaps, uncertainty.