Short-term risk premiums and policy rate expectations in the United States

Release date
26/09/2016
Reference
AN2016/07
Authors
Leo Krippner; Michael Callaghan
ISSN
2230‐5505

In recent years, Federal Funds Futures rates in the United States have been persistently lower than the Federal Reserve’s projections and analysts’ surveyed expectations of the Federal Funds rate.

We present a case for the difference based on risk premiums, the compensation that holders of securities demand for bearing risk, or return they are prepared to forego to avoid risk. In particular, it may be that market participants are at present willing to pay an insurance value to own high-quality interest rate securities (i.e. accept a negative risk premium) because such securities would outperform in the event of an unexpected economic downturn. Financial market factors, such as the expanded Federal Reserve balance sheet from quantitative easing, may also be contributing to negative risk premiums.

We estimate risk premiums from a term structure model and find they are of a sign and magnitude that would readily account for the differences mentioned in the first paragraph, and are plausible economically. Besides providing a rational reconciliation for the differences, a further implication from our negative risk premium estimates is that the expected path of the Federal Funds rate in the United States may currently be materially higher than might be inferred directly from the prevailing rates on the current series of Federal Funds Futures contracts.