Monetary Policy, Equity Markets and the Information Effect

Abstract

Central banks analyse copious amounts of information to assess the economic outlook to then set monetary policy. So, could changes in monetary policy reveal some additional information about the economic outlook to the public? This channel is known as the 'information effect'. The information effect posits that, in addition to the usual effects of monetary policy, agents interpret an interest rate increase as signalling some additional positive economic information. This effect, if strong enough, could then lead to dynamics where an increase in interest rates causes an expansion in economic activity. I evaluate whether the information effect can be detected in Australia through the lens of equity markets. I find that, contrary to the predictions of the information effect, a surprise monetary tightening from a monetary policy announcement causes equity prices to fall. I also show that this response in equity prices is, at least in part, driven by downward adjustments in expected earnings growth. These responses are consistent with conventional views of the effects of monetary policy. However, looking beyond monetary policy announcements yields some evidence that an information effect could be present through other forms of Reserve Bank of Australia (RBA) communication. I find speeches delivered by the RBA Governor generate responses in equity prices and earnings forecasts consistent with the information effect. But this result appears to be the exception rather than the rule. For most monetary policy communication, at least in equity markets, the information effect is not an important channel of monetary policy.

Assessing Australian Monetary Policy in the Twenty-First Century

“…12 However, this view conflicts with RBA 12 The RBA's July 2019 board minutes state that 'members recognised the negative confidence effects for some parts of the community arising from lower interest rates'. research (He 2021) which concludes there is little evidence for such an "information effect" being caused by changes in the RBA's cash rate.…”

Assessing Australian Monetary Policy in the Twenty‐First Century*

“…This concern was specifically cited by the RBA as a reason why the bank did not decrease nominal interest rates in 2019. 12 However, this view conflicts with RBA research (He, 2021) which concludes there is little evidence for such an "information effect" being caused by changes in the RBA's cash rate.…”

Can we Use High‐Frequency Data to Better Understand the Effects of Monetary Policy and its Communication? Yes and No!*

“…Over this period there are 11 such meetings per year (the first Tuesday of every month apart from January), giving us 199 events in the full sample. 2 We also consider a broader set of events examined in He (2021), though we incorporate data only from 2006 to 2019 (as earlier data were not available). This includes speeches, release of the board minutes and release of the Statement on Monetary Policy.…”

“…Jarockinski and Karadi (2020) and Miranda‐Agrippino and Ricco (2021) show that ignoring these information shocks leads to biased estimates of the effects of monetary policy. He (2021) explores these information shocks in the Australian context, finding some evidence that speeches contain such information, but little evidence for other communication.…”

“…We also consider a broader set of events examined in He (2021), though we incorporate data only from 2006 to 2019 (as earlier data were not available). This includes speeches, release of the board minutes and release of the Statement on Monetary Policy .…”