Central bank communication, transparency and interest rate volatility: Evidence from the USA

The FOMC has changed its way of communication twice, recently: from 2000-2003, the Committee imparted information about its assessment on the economic outlook (the balance-of-risk statements) and since August 2003 the FOMC informs additionally about its outlook’s implications on the future federal funds target rate (forward-looking language). The result should be that agents do not need to deduce FOMC’s likely policy move on every twitch of central bank communication and macroeconomic news. Markets have anticipated FOMC policy decisions on the day of the meeting very well since 1994. Therefore, the focus of the paper is on the behaviour of market rates between FOMC meetings and on testing for greater ‘smoothness’ and lower volatility of market rates since 2000. We apply an EGARCH model to forward rates at the short end of the yield curve. The model is used to test for the effects of the three disclosure regimes (pre-2000, 2000-2003, post-2003) on the dependence of previous and current changes of the market rates in the conditional mean equation. It is expected to observe higher inertia during the periods when market participants are better informed. Furthermore, generally, news increases interest rate volatility, since markets adjust interest rates in response to relevant news. However, other FOMC communication (other than the press statements after the FOMC meeting), may have a lower news value in the new disclosure regimes than it had in the pre-2000 period. Therefore, ‘other’ central bank communication may affect the volatility of interest rates differently in the three different regimes. This effect is tested for in the conditional variance of the regression model. We find that there is evidence of differences in smoothness between the period until 2000 and the period of the balance-of-risk statement. Furthermore, we find that the effect of other than Fed press statements after FOMC meetings varies in the three periods. This is particularly so for Fed communication concerning economic outlook and speeches by the chairman of the Board.