The Pavlovian response of term rates to Fed announcements

The traditional view of the monetary transmission mechanism rests on the premise that the Federal Reserve (Fed) controls the level of the federal funds rate via open market operations and the liquidity effect. By contrast, this paper argues that the Fed also manipulates the federal funds rate via public disclosures of the new level of the federal funds rate target and the "announcement effect." We define the announcement effect as the portion of interest rate movements associated with public statements on interest rate targets that do not require conventional open market operations for their support. This paper provides evidence on how the Fed uses the liquidity effect in conjunction with the announcement effect to execute monetary policy. In addition, it investigates the implications of the announcement effect in term structure behavior and the rational expectations hypothesis.