Federal Funds Futures, Risk Premium, and Monetary Policy Actions
Format of Original
Taylor & Francis (Routledge)
Applied Financial Economics
This article attempts to determine whether controlling for the time-varying risk premium would improve the ability of the federal funds futures to predict the Federal Open Market Committee's (FOMC) decision regarding the direction and magnitude of changes in the federal funds target rate at different forecast horizons. This is done using an appropriate categorical dependent variable model, which is estimated using real-time monthly data covering the period from January 1994 through September 2008. Following Piazzesi and Swanson (2008), control is made for the risk premium using a number of business-cycle indicators including nonfarm payrolls, the industrial production index, the help wanted index, and a measure of the Treasury yield spread. The results indicate that accounting for the risk premium modestly improves the predictive performance of the futures rate for the longer forecast horizons. Moreover, such a control appears to alleviate the over-prediction of changes in the target rate by the futures rate that has been documented in the literature.