Federal Reserve and Monetary Policy: Does the fed funds future market influence the Fed

Bernanke's speech: Implementing Monetary Policy is very interesting. However, it begs a question to be asked; ”Does the fed funds future market influence the Fed”? Bernanke does point to a paper in which “Orthogonality” to the equity market is addressed. See link: What Explains the Stock Market’s Reaction to Federal Reserve Policy? Page 11.

Excerpt:
As noted above, the event-study results reported in section 2.2 rely on the assumption that the error term is orthogonal to funds rate changes. One reason for a violation of this condition would be a contemporaneous response of monetary policy to the stock market. There are, however, no clear examples of instances in which a drop in equity prices led the FOMC to cut rates, or the inverse. Even in monthly data, evidence for such a systematic reaction is elusive. Moreover, to the extent the FOMC did respond in this way, it would tend to reduce the size of the estimated response to the funds rate surprise.

However, the fed funds future option is not the equity market, it is a derivative market. There is a difference. The fed funds future option is a derivative, which makes it an easy target for manipulation. All one needs to do is to influence other indexes in a few of the many derivatives out there and bang!!!! You get price movements in the fed funds options as traders either scurry for cover or react to the “trend is your friend” mentality.

The “What Explains the Stock Market’s Reaction Federal Reserve Policy?” paper does show that the Fed has no ideal what is going on in the US economy. One look at the paper A Guide to FRB/US page 4 points out the problem to Greenspan's conundrum of the long maturity bond market.

Excerpt:
Equations for financial variables are based on arbitrage equilibria. For example, arbitrage equates the rate of return on a bond to a weighted average of expected future values of a short-term interest rate plus a term premium. Because transactions costs are relatively small in financial markets, arbitrage is assumed within each quarter.

This is the first step to building the forecast used by the Fed. It is no longer correct. People are using their homes as “Banks”. This action adds a new term to the money velocity equation. It also adds a new constraint on how interest rates can be distributed without over compensating any given imbalance. FRB/US must now have at least one mid and long bond term (in effect, the shape of the yield curve). Even though these two additional terms are longer in scope, with respect to the forecasting time scale aspect of FRB/US, they are as, if not more important, than short term rates. The rate of equity build in ones home and the rate of a home-owner's ability or desire to change that equity into liquidity is effected by the perceived future value of one's home. This implies that a small change at the long end can have a larger effect than a small change at the short end.