Monetary Policy News and Exchange Rate Responses: Do Only Surprises Matter?

month) contract. By construction of the contracts, Fed funds futures rates implicitly embody predictions
of the monthly average of the daily Fed funds rate for a future calendar month. For example, when the
price of the one-month ahead contract changes on any given day in, say, January, this implies that market
expectations of the average price of the Fed funds rate over the month of February has changed. Early
studies by Carlson, McIntire and Thomson (1995) and Krueger and Kuttner (1996) show that Fed funds
futures rates provide efficient and unbiased predictors of future funds rate movements at short horizons.
Recent papers by Chernenko, Schwartz and Wright (2004) and Piazzesi and Swanson (2004) find a 3
basis point premium at one month horizons and a 6 basis point premium at two month horizons,
illustrating that the longer the horizon the less useful a predictor is the Fed funds futures contract.

As pointed out by Kuttner (2001), there are two technical issues involved in using the Fed funds
futures data for measuring expectations of future monetary policy. First, the Fed funds futures settlement
price is calculated as an average of the relevant month’s Fed funds rate. Second, the Fed funds future is
not based on the actual policy instrument, the targeted Fed funds rate, but on the effective market rate.
Kuttner (2001) carefully addresses these issues and computes a policy surprise measure based on the one-
day change in the spot-month future rate, utilizing the fact that the day-t futures rate embodies the
expected change on (or after) date t+1. If the target rate change occurs as expected, the spot rate will
remain unchanged, while a deviation from the expected rate will cause the futures rate to change (in
proportion to the remaining number of days affected by the unexpected change). For all but the first day
m

of the month, he computes the one-day surprise for date t as -----( f_{s t} - f_st-1), where m is the number

m-t ^{,      ,}

of days in the month and f_s,t is the spot-month futures rate on day t of month s. For the first day of the
month, the one-month futures rate from the last day of the previous month replaces the term f_s,t-1 .

The 42 monetary policy change events and the decomposition of the actual change into the
respective expected and unexpected components, respectively, are displayed in Kuttner (2001, p. 532).

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