Monetary Policy Expectation Errors

Abstract

We use survey data on expectations about future monetary policy to decompose excess returns to fed funds (FF) futures and overnight index swaps (OIS) into a term premium and an expectation error component. We find that excess returns are almost entirely driven by expectation errors, while term premia are slightly negative and economically small. We show that most of the expectation errors stem from market participants underestimating how aggressively the Federal Reserve has eased policy during the last three decades. Our evidence suggests that market participants at the time were unaware of changes in the central bank's reaction function, in particular the importance attributed to deteriorating financial conditions and falling stock market returns. We confirm our main results in an international sample of six major currency areas.