On April 18, 2001 US Federal Reserve Open Market Committee (FOMC) surprised …nancial markets by lowering the Federal Funds Target rate 1 2 % between regularly scheduled FOMC meeting dates. Securities markets in the US and Australia responded. The US 30-Euro$ rate fell by 1 2 %.and US and Australian …ve year bond yields fell by about 13 basis points. Equity returns increased by 3% in the US and 1 1 2 % in Australia. This paper is the …rst to examine international monetary policy surprise spillovers and to estimate the response of security prices to unobservable monetary and nonmonetary surprises.Our estimates of the impact of domestic monetary policy surprises on domestic yields and returns are similar to other studies. The following results are new. US monetary policy surprises spill over and a¤ect Australian yields and equity returns. Australian monetary surprises do not spill over to the US. Nonmonetary surprises are more important in explaining the movements in longer maturity yields and returns than monetary policy surprises.

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Abstract:This paper contributes to a recent literature that tries to filter exogenous monetary policy surprises from high frequency (daily) data. The literature uses the fact that monetary policy surprises are realized only on days that the Federal Reserve changes the Federal Funds Target, or on days that the Federal Open Market Committee (FOMC) meets and does not change the target-so-called "event days". We add to the literature in three ways: (1) we specify a more general model in which security prices respond to two sources of systematic risk (a two factor model)-a common information shock and the monetary policy shock-plus nonsystematic risk-an idiosyncratic shock. (2) We use all of the daily data while other studies use only a small sub-sample of less than 10% of the data. And (3) we use new estimation strategy that gives consistent and more efficient parameter estimates than previous studies.Our empirical results show that efficiently estimating a more general model leads to important differences. Common shocks have an important and statistically significant impact on bond yields at all maturities. Leaving out the common information shocks leads to bad estimates of the impact of monetary policy shocks. Cochrane and Piazzesi's event study found that the yield on a 10 year bond increases in response to a positive Target surprise-which they properly label a puzzle. The factor model solves the puzzle. We get the classic textbook response-a surprise increase in the target rate leads to a decline in the yield on the 10 year bond. Finally we look at equity returns as well as bond yields which introduces a different puzzle. In any model we look at a positive Target surprise causes a large and significant decline in equity returns. A recent event study paper of equity market responses by Bernanke and Kuttner (2003)

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