Monetary Policy Expectation Errors
73 Pages Posted: 8 Apr 2020 Last revised: 13 Apr 2021
Date Written: March 12, 2020
We use survey expectations about future monetary policy to decompose excess returns on fed funds futures and overnight index swaps into a term premium and an expectation error component. We find that excess returns are primarily driven by expectation errors, while term premia are economically small and negative on average. Most expectation errors stem from market participants underestimating how aggressively the Federal Reserve has eased policy during the last three decades. Our findings reveal that market participants are continuously learning about the central bank's reaction function and have been slow to recognize the rising importance attributed to deteriorating financial conditions and falling stock prices. We document similar results in an international sample of six major currency areas.
Keywords: Fed funds futures, overnight index swaps, forecast evaluation, expectation formation, monetary policy
JEL Classification: E43, E44, G12, G15
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