EXPLAINING AND FORECASTING THE US FEDERAL FUNDS RATE

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1 EXPLAINING AND FORECASTING THE US FEDERAL FUNDS RATE

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3 Explaining and Forecasting the US Federal Funds Rate A Monetary Policy Model for the US MATTHEW CLEMENTS

4 Matthew Clements 2004 Softcover reprint of the hardcover 1st edition All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act First published 2004 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin s Press, LLC and of Palgrave Macmillan Ltd. Macmillan is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN ISBN (ebook) DOI / This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress

5 To Vanessa and Jim for your friendship and encouragement

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7 Contents List of Figures List of Tables Acronyms ix xi xiii Introduction 1 1 Monetary Policy Models 5 Introduction 5 The Taylor rule 8 Explaining deviations in the Taylor rule from the actual FFR 14 Variations on the Taylor rule using other data 18 Discretion versus rules based monetary policy 20 Data used in monetary policy models 22 2 Monetary Policy at the US Federal Reserve 27 Introduction 27 The history of Fed policy since Fed targets and policy instruments 41 3 The Monetary Policy Model (MPM) 47 Introduction 47 Applications of the MPM 47 The MPM equation 49 Explaining deviations in the MPM from the actual FFR 55 vii

8 viii CONTENTS Using the MPM 60 Modifying the MPM during crisis periods 63 Using the modified MPM 65 Assessing the accuracy of the MPM in describing the FFR 67 4 Making FFR Forecasts Using the MPM 69 Introduction 69 Using CBO economic projections with the MPM to estimate the future FFR 70 Making one year ahead FFR forecasts 71 Making two year ahead FFR forecasts 72 Making two year ahead average FFR forecasts 72 Making three to five year ahead forecasts 73 5 Comparing MPM Results with the Eurodollar Futures Market 75 Introduction 75 One year ahead futures prices 76 Two year ahead futures prices 77 Two year ahead average futures prices 78 Comparing the two year ahead average forecasting errors of the MPM and eurodollar futures strips 81 APPENDICES 83 Appendix 1: Historic economic data ( ) 85 Appendix 2: Eurodollar futures: historical data ( ) 93 Appendix 3: The Federal Funds Rate ( ) 103 Appendix 4: A comparison of different US inflation measures ( ) 127 Appendix 5: The MPM and FFR ( ) 129 Bibliography 135 General Notes 139 Index 143

9 Figures 1.1 M2 money supply growth (y/y) and CPI inflation (y/y) The Taylor rule based on quarterly data The Taylor rule based on annual data Taylor rule using expected inflation using quarterly data Taylor rule using CPI inflation using quarterly data Taylor rule using annualized GDP data using quarterly data The GDP deflator and the FFR Fed chairmen and the FFR since US CPI and GDP deflator inflation and the FFR ( ) Arthur Burns Paul Volcker Alan Greenspan 1987 present Alan Greenspan 1995 present M1 money growth (y/y) and the FFR, The MPM and FFR : quarterly data The MPM and FFR : annual data The FFR and GDP deflator Real GDP ix

10 x CONTENTS LIST OF FIGURES 3.5 The real FFR rate (adjusted for the GDP deflator) Three-month real commercial paper rate The modified MPM and the FFR : quarterly data The modified MPM and the FFR : annual data The MPM from two year average CBO forecasts and the FFR Two year ahead average MPM and eurodollar futures strips ( ) 80 A.1 US inflation measures ( ) 128

11 Tables 1.1 Components of gross domestic product (GDP) for Statistics under different Fed chairmen The average MPM, modified MPM and FFR: quarterly data The average MPM, modified MPM and FFR: annual data Absolute percentage-point errors in describing the FFR, and The economic outlook, January 1999: the CBO forecast for 1999 and One year ahead CBO economic forecasts and MPM results Two year ahead CBO economic forecasts and MPM results Two year ahead average CBO economic forecasts and MPM results CBO forecasts made in January 1997 for the years Accuracy of the MPM and EDF strip in estimating the average FFR for the coming 12 months ( ) 76 xi

12 xii CONTENTS LIST OF TABLES 5.2 Average two year ahead MPM rate based on CBO forecasts made in January each year Comparing the implied FFR from the EDF strips in January and March of each year and the MPM constructed from CBO forecasts with the actual FFR for the years Two year ahead average forecasting errors of the MPM and EDF strips 81

13 Acronyms BEA CBO CPI EDF Fed FFR FOMC GDP IMF MPM OECD PCE Bureau of Economic Analysis US Congressional Budget Office consumer price index eurodollar future US Federal Reserve federal funds rate Federal Open Market Committee gross domestic product International Monetary Fund monetary policy model Organization for Economic Cooperation and Development personal consumption and expenditure xiii