On Wednesday, the Fed unexpectedly announced that it would maintain low interest rates at least until unemployment had dropped below 6.5 percent, and that it would tolerate inflation of up to 2.5 percent in order to get there. This was more aggressive forward guidance than it had ever given before, and if the Fed’s guidance is effective, it should have had an effect on medium-term interest rates. So did it?
The chart on the right shows the yield of 10-year treasury bonds on Wednesday. In the morning, before the Fed announcement, they were trading around 1.65-1.66. After the Fed announcement they were trading around 1.69. That’s an increase of about two percent.
I’d like to hear from the market monetarists about this. Does a change of this magnitude mean the Fed’s guidance was effective? Or ineffective? My recollection—which might be wrong!—is that forward guidance isn’t supposed to affect interest rates gradually. It’s supposed to have an immediate impact, so it should be soon enough to comment on this. Anyone?