Options-Based Expectations of Future Policy Rates

Forecasts of short-term interest rates that are based on futures rates in financial markets can be very misleading when the policy rate is near the zero lower bound. By contrast, options on future short-term interest rates can provide more accurate projections. Currently these options suggest that the federal funds rate—the Federal Reserve’s key monetary policy interest rate—is most likely to lift off from zero around mid-2015 and rise only slowly afterwards at a pace of about 1 percentage point per year. During “normal ” times for monetary policy, the short-term interest rate is the main policy instrument, and it is a comfortable distance away from zero. In this situation, it is fairly straightforward to see what financial market investors expect the central bank to do in the near future. In particular, rates on money market futures and forward rates for government bonds reflect investors ’ expectations for the future path of short-term rates. Hence, anyone interested in the market’s view of future monetary policy can calculate it simply from observed interest rates. However, we are not in normal times. Short-term interest rates, including the federal funds rate—the policy rate targeted by the Federal Reserve—have remained at essentially zero since December 2008. The current situation in which short rates are fixed close to zero is referred to as the “zero lower bound