Federal Funds Futures, Spot Rates, and Expected Changes in Monetary Policy

Market participants, researchers and policy makers often use Federal funds futures as a proxy for the market's expectation of changes in monetary policy. This paper examines how well the Fed funds futures rate predicts changes in the Fed fund target rate relative to what the spot rate predicts. This approach differs from previous tests of information content of futures prices. Tests for the information content of futures prices often look at how well the futures prices predict the changes in spot prices. These tests may be thought of as incremental in the sense that they test the incremental benefit of adding more information (the futures price) to the null model. In the case of Fed funds futures, we may want to know whether futures or spot rates have more information about future changes in the Fed funds target rate. The paper identifies two separate models of expected changes in monetary policy. One model uses information embedded in the spot rate, while the other uses information embedded in the futures rate. The paper uses an encompassing regression framework to test the relative ability of the two models in predicting changes in the target rate. Results indicate that the relative information content of the futures rate has varied over time. During the period of initial futures market formation, the futures and spot rates have the same information. More recently, however, the futures rate seems to contain more information about future changes in monetary policy than the spot rate contains.