The Announcement Effect: Evidence from Open Market Desk Data

he textbook view of the monetary transmission mechanism rests on the central bank’s ability to manipulate the overnight interest rate by controlling the reserve supply, followed by a rational-expectations mechanism that ensures that movements in the overnight rate reverberate into longer maturity rates. However, while few dispute the fact that the central bank controls the overnight rate effectively, the notion that it does so via a liquidity effect and the nature of term structure relationships needs to be reexamined. Modern central banking is generally characterized by public announcements of an interest rate target, such as the federal funds rate target in the United States. In some cases, central banks (such as the Bank of Australia and the Bank of England) also disclose an inflation target, while in extreme cases, the banks (such as the Reserve Bank of New Zealand) disclose the parameters of the policy reaction function. These actions constitute a significant departure from traditional central banking. It is natural to question why central banks have abandoned their once-secretive behavior in favor of public disclosures of policy moves. Likely reasons include the desire for better and more precise control of the overnight rate, and, more important, enhanced communication of future policy moves—in essence, the Holy Grail of controlling long rates by also manipulating expectations. This paper investigates these issues as they relate to the U.S. Federal Reserve. In particular, we focus on how the Federal Reserve’s 1994 policy change—by which it began announcing the target level for the federal funds rate—had an impact on the liquidity effect and the manner in which the central bank uses open market operations to control the federal funds market. We also examine what effect this policy change may have had on the behavior of the term structure. Prior to the Federal Reserve’s Federal Open Market Committee (FOMC) meeting in February 1994, monetary policy objectives for the federal funds rate and the outcome of the FOMC meeting itself had been confidential and had never been announced. After the policy change occurred, and inspired by similar developments in other central banks, Demiralp and Jordá (2000), Guthrie and Wright (2000), Taylor (2001), Thornton (2001), and Woodford (2000) began to investigate a central bank’s ability to control the overnight rate—not merely through traditional open market operations, but by effectively communicating the desired level of the overnight rate and standing ready to enforce that level. As Meulendyke (1998) observes, “the [federal funds] rate has tended to move to the new preferred level as soon as the banks know the intended rate.” In this paper, we term this method of controlling the overnight rate the announcement effect (following Demiralp and Jordá [2000]); this effect differs from the conventional liquidity effect in that the volume of open market operations required to signal the new target level is substantially smaller because of expectations. Selva Demiralp and Oscar Jordá