The Announcement Effect: Evidence from
Open Market Desk Data
Selva Demiralp
Board of Governors of the Federal Reserve System
Oscar Jordá
University of California, Davis
April 5, 2001
Prepared for the Federal Reserve Bank of New York Conference
“Financial Innovation and Monetary Transmission,” April 5-6,
2001.
Announcement Effect
The market’s reaction to the announcement
of a new target for the overnight rate that
causes the overnight rate to trade around the
new target with few to no open market
operations.
Previous Literature
Guthrie and Wright (2000), Woodford
(2000), Taylor (2001), and Thornton (2000)
Demiralp and Jordá (2001)
“The Pavlovian Response to Fed
Announcements”
1
Questions
 Has the post-1994 period of policy
announcements changed the manner in
which the Fed uses open market
operations to control the federal funds
market?
 What effect, if any, did this change in
policy have on the behavior of the term
structure?
2
What do we expect to find?
 Open market operations are no longer
needed as a “signaling device” to modify
the federal funds rate in the direction of
the new target level.
 The Announcement effect regiments the
formation of expectations in longermaturity term-rates.
3
Taylor (2001)
A textbook model of the daily reserves market
(i)
Demand for Reserves
Rtd     ( f t   Et f t 1 ) 


Speculative Demand
where

ft
 t
,
Precautionary Demand
 ,  , ,   0
 Changes in the effective funds rate lead
to movements along the demand curve.
 Changes in the expected rate lead to
shifts in the demand schedule, which
eliminates any arbitrage opportunities.
4
(ii) Supply of Reserves
Rts  Rt 1   ( f t 1  f t *1 ) ,
 0
 For a given level of the target, the
Federal Reserve adjusts reserves to
offset daily deviations of the effective
rate from the target.
 For a given level of the funds rate, the
Federal Reserve changes the reserve
supply that is consistent with a new
target level (i.e. whenever the target rate
is changed).
5
Figure 1: A General Model of the Reserves
Market with Anticipated Policy Actions
S1old
E1old
S1new
S0
E1new
f1*
E0A
f0
E0
f 0*
E0B
D1
D0
O
NBR1old
NBR1new
NBR0
NBR* 0
Reserves
Rts  Rt 1   E t 1 ( f t  f t * )
6
Open Market Operations and Target
Announcements
Two questions:
 Is there any difference in the size of
operations needed to signal a new level for
the target?
 Is there any difference in the portfolio of
operations used in this signaling?
Samples:
 April 25, 1984 to February 4, 1994
 February 4, 1994 to August 18, 1998
 August 18, 1998 to August 14, 2000
7
Types of Operation
Adds Liquidity
(Purchases)
Detracts Liquidity
(Sales)
T-Bill domestic purchases
Permanent
(Outright)
T-Bill Sales
T- Bill foreign purchases
Coupon domestic purchases
PB
Coupon Sales
PS
Coupon foreign purchases
Temp.
Term RP purchases
Term Matched Sale
TB
Overnight RP
Overnight
Purchases
Purchases
TS
Overnight Matched
OB
Sale Purchases
OS
Percent of the Time each Type of Operation is Executed
Operation
Pre-1994
Post-1994
PB
0.32
0.13
TB
0.13
0.27
OB
0.10
0.36
PS
0.03
0.02
TS
0.03
0.01
OS
0.05
0.04
Percent of the Time any Operation is Executed
0.55
0.67
8
What Day of the Maintenance Period Are Target Changes
Most Often Executed?
Pre-1994
Post-1994
Day 1 – Thurs.
0.37
0.05
Day 2
0.06
0.05
Day 3
0.02
0.05
Day 4
0.04
0.20
Day 5
0.07
0.05
Day 6 – Thurs.
0.22
0.05
Day 7
0.10
0.00
Day 8
0.03
0.00
Day 9
0.03
0.40
Day 10
0.05
0.15
Adjustments
x jt 
~
x jt
TRs (t )1
9
Decomposing the gap: ft – ft*


NEEDt  f t  f m*(t )1  wt* Em(t )1 f m*(t )

EXPECTt  Em(t )1 f m*(t )


SURPRISE t  f t*  Em(t )1 f m*(t )

f
*
m( t )1


value of the target at the start of the
maintenance period.
 wt* probability distribution of target changes
within the maintenance period.


*
E

f
m ( t ) beginning of the maintenance
 m(t ) 1
period expectations of a target change.
 SURPRISEt = 0, except when ft* is non-zero.
 ACH Model  Beginning of the maintenance
period expectations of a target change.
10
Open Market Operations as a Function of the
Effective-Target Federal Funds Rate Gap
OMO
OS
xOB
OB
cOB
cOS
ft – ft*
Tobit Specification:
0

x jt  
x *
 jt
if
x *jt  c j
if
x *jt  c j
x *jt   j ( f t  f t * )   t
11
Specification
10
3
x    k d    i X t'i 
*
jt
10

k 1
k 1
10
k
N
k
t
i 1
3
d NEEDt 1    d EXPECTt 1    Si SURPRISE t i   jt
k
t
k 1
k
E
k
t
i 0
 k : modifies the threshold. Allows
operations to be more likely certain days of
the week.
 i : conditions on past and unobserved
information. Complement vs. substitute
operations.
 N,Ek : the responsiveness of the Desk varies
according to the day of the m-period.
 Si : contemporaneous and up to three lag
dynamic pattern of operations in the days
surrounding the announcement.
12
Table 2 – Signs of the Coefficients in the TOBIT Regressions: Purchase Operations
1984-1994
Need
Day
1994-1998
Expected
Need
1998-2000
Expected
Need
Expected
OB TB PB OB TB PB OB TB PB OB TB PB OB TB PB OB TB PB
+
.
.
.
.
.
.
++
.
--
++
.
.
.
.
Friday
++
.
.
.
++
.
++
.
.
.
.
.
--
.
.
Monday
+
.
.
.
.
.
.
.
.
.
.
.
.
+
.
.
.
.
++
.
.
.
.
.
+
_
.
.
.
+
.
.
.
.
.
.
.
++
.
.
.
.
++
.
.
--
.
.
.
.
.
.
_
++
.
.
.
.
.
.
.
.
-
.
+
.
.
.
.
.
.
Friday
++
.
.
.
.
.
.
.
.
.
.
.
++
.
.
.
.
.
Monday
+
.
.
.
.
.
.
.
.
.
.
.
+
.
.
-
.
.
++
.
.
.
.
.
.
.
.
.
.
.
+
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
Thursday
.
++
.
++ ++
.
1
2
3
Tuesday
4
Wednes.
5
Thursday
6
7
8
Tuesday
9
Wednes.
+
10
Surprise – Lag
0
--
-
.
+
.
.
.
.
.
1
.
+
.
-
.
+
.
.
.
2
--
.
.
.
.
.
.
.
.
3
.
.
.
.
.
.
.
.
.
13
Results
Frequency each operation is used
Operation
84-94
94-98
PB
OB
31.91%
10.04%
11.18%
26.50%
98-00
16.51%
58.16%
 84-94: OB operations most responsive to
variations in NEED but also period in which
ft – ft* deviations are most persistent.
 94-98: OB operations concentrate on first
Friday and midway through the period –
coincides with smallest ft – ft* deviations.
 98-00: OB less responsive overall coincides
with observed persistence in ft – ft*
 TB: Mostly associated with accommodation
of expectations early in the m-period.
 PB: Operations of a technical nature.
 SURPRISE: 84-94 consistent with liquidity
effect. 94-98 significant decrease in the
response. 98-00 virtually zero response –
consistent with announcement effect.
 Smoothing: Significant decline in the
persistence of operations.
14
Response of Term Rates to the Announcement
Kuttner (2000) Fed Funds Futures Rate Surprise
~ 

ms
f s0,  f s0, 1
ms  

E 1 (f* )  f*  ~
ms : number of days in month s
f s0, spot-month futures rate at date 
Agenda
 Has the predictive power of the futures market
improved since 1994?
 What is the response of term rates to changes
in the target?
 Tests of the timing hypothesis.
15
Predicting Changes in the Target
Notice f t 1  {0.50,0.25,0,0.25,0.50} . Assume
that the discrete changes in the target are related to
a latent index, such that
*
f t*1
 0.50 if
 0.25 if



 

if
 0.5
st 1  ( , c1 ]
st 1 
(c1 , c2 ]


st 1 
( c4 , )
(8)
with
*
st 1  E t ( f t*1 )   m d tmonth
E
(

f
1
t
t 1 ) 
*
fomc
*
 mp d tmp
1 E t ( f t 1 )   f d t 1 E t ( f t 1 )  u t 1
(9)
 wt 1  u t 1
So that, for example
P( f t*1  0.25 | wt 1 )  P( c 3  wt 1  u t 1  c 4 )
  ( c 4  wt 1 )   ( c 3  wt 1 )
(10)
16
Ordered Probit Estimates
Coefficient
Et (f t *1 )
At FOMC
End of Month
End of M. Period
Avg. Log-Lik
Pseudo R2
Observations
1989 – 1994
4.77**
(0.76)
6.12
(4.30)
-4.45**
(0.94)
1.74
(1.24)
-0.085
0.18
1229
1994 – 2002
7.19**
(1.20)
9.35**
(1.22)
-7.75**
(1.30)
0.26
(1.27)
-0.029
0.70
2089
Note: Estimates of limit points omitted. **(*) indicates significant
at the 99%(95%) confidence level.
Predicted Frequencies
Value
-0.50
-0.25
0
0.25
0.50
1989 – 1994
1994 – 2002
Actual Pred. Error Value Actual Pred. Error
3
1
2
-0.50
8
10
-2
21
0
21 -0.25
9
0
9
1207 1230 -23
0
2058 2067
-9
0
0
0
0.25
9
7
2
0
0
0
0.50
5
5
0
17
Term Rate Responses to Target Changes
Cook and Hahn (1989), Kuttner (2001)
Rt     1 Et 1 (f t* )   2~t  u t
Rt
Maturity
3-month
6-month
2-year
5-year
10-year
1
Response to
Anticipated
1989 –
1994 –
1994
2002
0.33**
0.07
(0.15)
(0.04)
0.29**
0.04
(0.13)
(0.04)
0.20
0.04
(0.17)
(0.05)
0.16
0.01
(0.16)
(0.06)
0.15
-0.03
(0.16)
(0.05)
(9)
2
Response to
Unanticipated
1989 –
1994 –
1994
2002
0.90***
0.82***
(0.13)
(0.12)
0.88***
0.63***
(0.11)
(0.11)
0.74***
0.51***
(0.14)
(0.15)
0.60***
0.39**
(0.13)
(0.17)
0.43***
0.25
(0.13)
(0.15)
Notes: expression (12) is estimated only on days in which the
target was changed. There are 24 observations for the pre-1994
(5/18/1989 – 2/3/1994) sample, and 31 observations for the post1994 (2/4/1994 – 2/1/2002) sample. Standard errors in parenthesis.
***/**/* indicates significant at the 99% /95%/90% confidence
level.
18
The Timing Hypothesis
R   0   f dFOMC   s dSW ITCH  10 E 1 (f* ) 
1f dFOMC E 1 (f* )  1s dSW ITCH E 1 (f* )dSW ITCH 
 20~   2f dFOMC~   2s dSW ITCH~  u
Timing
At FOMC
Outside FOMC
At FOMC+
SWITCH
Outside FOMC +
SWITCH
R2
3month
0.63**
(0.18)
0.78**
(0.07)
1.42**
(0.50)
1.58**
(0.53)
0.75
Maturity
62-year 5-year
month
0.18
0.30
0.13
(0.15) (0.20) (0.21)
0.60** 0.64** 0.49**
(0.07) (0.08) (0.09)
1.68** 1.73** 1.76**
(0.44) (0.56) (0.60)
2.09** 2.06** 2.12**
(0.47) (0.60) (0.64)
0.69
0.61
0.52
10year
0.02
(0.19)
0.34**
(0.08)
1.42*
(0.54)
1.74**
(0.58)
0.48
Notes: Standard Errors in parenthesis. **(*) indicates significant at
the 99%(95%) confidence level.
Calculation of the Coefficients:
0
f
 At FOMC:  2   2
0
 Outside FOMC:  2
 At FOMC + SWITCH:  20   2f   2s
 Outside FOMC + SWITCH:  20   2s
19
Conclusions
 The Announcement effect has reduced the
volume of open market operations necessary
to signal changes in the target level of the
federal funds rate.
 Public communication of policy has
regimented the formation of expectations on
future policy moves, improving the market’s
ability to forecast future changes.
 The announcement of policy moves
synchronizes policy-induced shifts in the term
structure in a manner consistent with the
expectations hypothesis.
20