Monetary Policy Expectation Errors
80 Pages Posted: 8 Apr 2020 Last revised: 4 Feb 2022
Date Written: March 12, 2020
Abstract
How are financial markets pricing the monetary policy outlook? We use survey expectations to decompose excess returns on money market instruments into expectation errors and term premia. We find excess returns to be driven primarily by expectation errors, whereas term premia are negligible. Our findings point to challenges faced by investors when learning about the Federal Reserve's response to large, but infrequent, negative shocks in real-time. Rather than reflecting risk compensation, excess returns stem from investors underestimating by how much the central bank would ease policy in response to such rare shocks. We document similar results in an international sample.
Keywords: Expectation Formation, Monetary Policy, Federal Funds Futures, Overnight Index Swaps, Uncertainty
JEL Classification: E43, E44, G12, G15
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