Central banks publically announce intentions of maintaining a key policy interest rate at a certain level called the “target rate.” The practice of announcing targets is relatively recent, and represents a sharp departure from the confidentiality and secretiveness that was once thought to be a necessary part of monetary policy and open market operations. The “announcement effect” refers to a central bank’s ability to control a key interest rate merely by announcing its intentions.
In the United States, the key policy interest rate targeted by the central bank is the federal funds rate, and the central bank is the Federal Reserve System. The federal funds rate is the interest rate at which commercial banks can borrow funds from each other overnight. The federal funds rate reflects the market tightness for these funds. The Federal Reserve can ease tightness in this market by purchasing U.S. government bonds, and can tighten this market by selling U.S. government securities. Buying U.S. government securities injects additional funds into the banking system, allowing banks to increase lending and enlarge the money supply in the process. Central bank purchases and sales of government securities are called “open market operations.” In the Federal Reserve System, a policy-making group called the Federal Open Market Committee (FOMC) formulates the policy for open market operations.
Until 1994, the Federal Reserve kept directives involving open market operations a secret until 45 days after an FOMC meeting, keeping current financial market participants unaware of the Federal Reserve’s policy stance at a given point in time. In 1976, the Federal Reserve successfully defended itself against an inquiry filed under the Freedom of Information Act to obtain copies of the minutes of FOMC meetings without the 45-day delay. Federal Reserve cited an “announcement effect” that might lead to volatility and uncertainty in financial markets, and maintained that secrecy was a necessary part of monetary policy.
On 4 February 1994, the FOMC, amidst a two-day meeting, announced that it planned to apply slight pressure to commercial bank reserve positions, and that short-term interest rates could be expected to rise, breaking the Federal Reserve’s long stance policy of secrecy in these matters. It was an experiment in clearly communicating policy decisions to financial markets, and using public announcements as a method of communication. The experiment had none of the dire consequences that the Federal Reserve cited in its 1976 defense against a Freedom of Information inquiry. The practice of publically announcing policy decisions and targets became a standard part of central banking in the United States and in numerous other countries. What became known as the “announcement effect” enabled central banks to control a targeted interest rate with fewer interventions in the open market. It gave central banks the ability to control a targeted interest rate merely by announcing its intentions and taking little or no immediate action.
See also: Federal Open Market Committee, Open Market Operations
References
Belongia, Michael T., and Kevin Kliesen. “Effects on Interest Rates of Immediately Releasing FOMC Directives.” Contemporary Economic Policy, vol. 12, no. 4: 79–91.
Demiralp, Selva, and Oscar Jorda. “The Response of Term Rates to Fed Announcements.” Journal of Money, Credit, and Banking, vol. 36, no. 3 (June 2004, part 1): 387–405.
