In a new Economic Letter, Michael Bauer, an economist for the Federal Reserve Bank of San Francisco, takes a look at the impact of news on bond markets.  Surprising data has an immediate impact on short-term interest rates, but what about long-term rates?  Bauer argues for examining the "entire term structure of interest rates."

Monetary policy actions, such as changes in the federal funds target, releases of Federal Open Market Committee (FOMC) statements, or speeches by committee participants, often contain new information relevant to financial markets. Importantly, while the Fed has direct control only over the federal funds rate, it can also affect interest rates at other maturities by changing expectations of future monetary policy. How does monetary policy affect the term structure? In what way does it affect longer-term interest rates, which are crucial in determining lending costs and mortgage rates, and strongly influence economic behavior? Looking at the entire term structure of forward rates reveals how much news about monetary policy changes perceptions of economic fundamentals and affects rates at different horizons. Specifically, changes in the term structure show whether policy actions directly affect distant forward rates or whether the effects die after medium horizons.

An important difference exists between macroeconomic news and monetary policy news. We can quantify economic surprises, but we do not have a measure that satisfactorily captures all aspects of policy surprises. The language of FOMC statements and speeches cannot easily be quantified. To capture the surprise component, researchers have focused on how policy actions affect financial markets (see Kuttner 2001). Thus, to assess the effects of policy actions, I employ the same model-based methodology I used with employment and inflation news, examining changes across the entire term structure of interest rates as policy surprises were made public.

Figure 3 shows the effects on forward rates of three Fed moves in 2007 to lower the federal funds target: a half percentage point cut on September 18, a quarter percentage point cut on October 31, and another quarter percentage point cut on December 11. These three easing actions had very different effects on the term structure. In September, the size of the cut surprised market participants. Short-term rates fell, but longer forward rates actually increased, which may have reflected an upward revision in expectations about economic growth. In October, forward rates at short and medium horizons increased on the day of the meeting, probably because markets had expected a larger federal funds rate move or a change in the language of the Fed’s policy statement. Thus, monetary policy was viewed as tighter than previously anticipated. Markets had anticipated the Fed’s December cut, so the short end of the term structure did not move much. But medium and longer-term forward rates fell significantly. Changing statement language apparently led market participants to expect much easier monetary policy over the medium and long horizons.

Read What Moves the Interest Rate Term Structure? here.