Monetary Policy Shocks and Security Market Responses

Abstract

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)

The macroeconomic effects of fiscal policy

“…Sack (2002, 2003) and Craine and Martin (2003) use a heteroscedasticitybased estimator and find a significant response of the stock market to shocks in the interest. Bernanke and Kuttner (2005) show that a hypothetical unanticipated 25-basis-point cut in the Federal funds rate target is associated with about a 1% increase in broad stock indexes.…”

Monetary Policy News and Exchange Rate Responses: Do Only Surprises Matter?

“…3 Recent papers by Bernanke and Kuttner (2004), Craine and Martin (2003) and Flannery and Protopapadakis (2002) follow the same approach in regards to using only the surprise element (the difference between announcement and expectation) of news as the explanatory variable when measuring the response of the stock market to monetary policy changes and other macroeconomic news. 4 We are only investigating the impact of US monetary policy news and, therefore, we do not rescale our news variables by their respective standard deviations.…”

Monetary policy and U.S. long-term interest rates: How close are the linkages?

“…Craine and Martin (2003) estimate a general factor model, which allows multiple sources of systematic risk, including monetary policy surprises, to affect long-term bond yields. They use daily data, as do the studies reported in lines 1-3, but use all observations instead of just those days on which policy shifts occurred.…”

“…Single-equation studies may suffer from an omitted variable problem. Craine and Martin (2003) provide evidence that this is the case. Moreover, singleequation estimates are based on a small sample mostly from the 1990s.…”