Let the Market Speak : Using Interest Rates to Identify the Fed Information Effect

This paper proposes a novel approach to disentangling a Fed information effect from an exogenous monetary shock using high-frequency interest rate changes around a monetary announcement. The approach relies on the different ways these two factors change short-term interest rates. The key to identification is to consider monetary announcements and macroeconomic data releases together and let the latter inform us how interest rates respond to news on economic fundamentals. My measure of the information component of Fed announcements is strongly correlated with the difference between market forecasts and the Fed’s own forecasts. It has the advantage over measures based on Fed forecasts in that researchers have to wait five years for the release of the Fed forecasts, whereas the measure proposed here can be constructed in real-time from publicly available data. When one removes the information component from the response to monetary announcements, a pure policy shock has a bigger effect on the economy than suggested using a high-frequency policy instrument with no adjustments. A tightening monetary shock that raises the three-month-ahead fed funds futures rate by 1% leads industrial production to decline nearly 2.5% ten months after the shock. The CPI also responds to monetary policy more quickly than is implied by other estimates