The Information Content of an Increase in Federal Funds Rate from a Zero Lower Bound Environment

Abstract

There has been much debate within the FOMC committee on when to raise the target rate from the 0 to 25 basis points range (zero lower bound) and the information conveyed to the financial community. This paper uses a recursive vector autoregressive model to examine the impact of an increase in effective federal funds rate (and shadow rate), from the zero lower bound, on corporate and municipal bond credit default swap (CDS) spreads. Our simulation indicates that on average, a 25 basis point increase in effective federal funds rate (shadow rate) results in a decrease of 59% (24%) in CDS spreads, thereby conveying good news about the economy. This reaction, however, is observed only for investment grade bonds. There are no significant changes in the CDS spreads on below investment grade bonds and buy and hold abnormal stock returns following a rate increase. Further, given that the Federal Reserve is targeting a 2% annual inflation rate, if the current annualized rate is 1.5%, we estimate that a 25 basis point increase in effective rate (shadow rate) would result in an annual inflation rate of 2.2% (1.9%) annual inflation rate. We interpret the rate increase as a weak but positive signal of economic recovery.