RDP 2021-04: Monetary Policy, Equity Markets and the Information Effect 9. Discussion, Limitations and Future Research

My results provide little evidence that the information effect of monetary policy is an important factor in the response of equity prices to monetary policy announcements in Australia. This runs counter to the findings of Campbell et al (2012) and Nakamura and Steinsson (2018), who find evidence of the information effect of monetary policy in the United States when observing forecast revisions of macroeconomic variables by professional forecasters. Notwithstanding this, the results are consistent with other research that focuses on the effects of monetary policy on equity prices (Bernanke and Kuttner 2005; Bauer and Swanson 2019). The results also survive a variety of robustness tests.

Delving deeper into the equity prices findings, I also find little evidence for an information effect in equity earnings growth forecasts. Instead, consistent with the moves in equity prices, I find that a monetary tightening causes forecasters to revise down their expectations of earnings growth. This implies that the decline in equity prices following a contractionary monetary policy surprise is driven by both a decline in expected dividends and an increase in the discount factor. Moreover, looking across industries suggests that the decline in earnings forecasts following a tightening in monetary policy is broad based but strongest in exchange rate-exposed sectors. This is unsurprising as it is well documented that the exchange rate is an important channel for monetary policy in Australia.

Extending the analysis to include other forms of central bank communication outside of the monetary policy announcement reveals that the information effect could be stronger across different communication channels. Specifically, I find some evidence that speeches delivered by the RBA Governor produce responses consistent with the information effect; contractionary monetary policy surprises induced by Governor speeches drive increases in equity prices and forecasted equity earnings. This indicates that the information content of speeches by the RBA Governor, on average, outweighs other monetary news. However, I find some evidence that this effect could be driven by communication of changes in (or new information about) the reaction function. Nonetheless, the result is consistent with international research on central bank communication (Cieslak and Schrimpf 2019). The findings suggest that Governor speeches could potentially influence the information set and expectations of private agents. Indeed, this result could reflect a deliberate strategy by the RBA to use Governor speeches to release information. One implication of this is that ‘jawboning’ could indeed play a role in the monetary policy toolkit.

This paper's findings have implications for the conduct of monetary policy in Australia. Specifically, at first sight, the work suggests that concerns over the information effect of monetary policy in Australia should be small when constructing an optimal monetary policy prescription. However, the work also highlights that central banks could deliberately use specific forms of communication to convey information to the public. Despite this, it is important to consider the limitations of this research.

First, the focus on this paper is on Australian equities, which may not be representative of Australian households and firms. It is possible that the findings in this paper do not reflect the total effects of monetary policy, as the information effect may be a stronger channel of monetary policy in areas outside of the equity market, such as household consumption and business investment decisions.^[15]

This research is silent on whether the findings can be extrapolated beyond the variables examined directly. I leave this for future research to explore.

Second, the evidence of an information effect from Governor speeches should be interpreted with caution. It is unclear if the information from Governor speeches would have been revealed at a later time had it not been contained in the speech. If the information would eventually be revealed in the absence of the Governor's speech, we would observe an increase in the OIS curve, equity prices and forecasted earnings when the information gets revealed. This would suggest that any information effect from central bank communication is simply shifting the timing of news. To better understand this channel, future research should attempt to disentangle whether Governor speeches create news or simply shift the timing of news. Moreover, even if the results suggest there is some space for ‘jawboning’ in monetary policy communication, it is likely unwise to consistently exploit this relationship. Such a strategy is subject to the Lucas critique, as continued ‘jawboning’ would likely erode the credibility of the central bank (which the information effect is predicated on) if the communicated state of the economy does not match the realised state. This idea is similar to Stein (1989), where agents understand that the central bank has incentive to mislead the public and therefore do not place weight on certain forms of central bank communication.

Third, though over the sample the estimates show little evidence of structural breaks, it is possible that changes in the monetary policy regime could lead to the information effect being a larger channel of monetary policy. For example, the constructed monetary policy surprise series could be interpreted as a level shift in the OIS curve. This may not necessarily be how monetary policy announcements are internalised in the OIS market in the future. This may especially be the case in the current situation where the RBA's cash rate target is close to the zero lower bound and the RBA has also implemented a yield curve target for the 3-year government bond rate.

Lastly, it is worth remembering that although I find evidence that the standard channels of monetary policy dominate the response to policy changes on average, this does not preclude the possibility of the information effect existing. It is merely that whatever the information effect, it is sufficiently small that it doesn't affect our standard understanding that increases in interest rates are contractionary and decreases are expansionary.

Though unrelated to optimal policy, another limitation of this paper is that it does not attempt to quantify the role of risk premia in the response of equity prices. It is relatively simple to conclude the zero coupon rate changes when there are surprise changes in monetary policy and I also show that expectations of earnings growth decline in response to surprise monetary tightening. However, as premia are unobserved and must be estimated, I cannot completely disentangle and attribute the relative contributions of each component of equity prices in determining the response of equity prices to monetary policy. Though identifying the changes in premia are unlikely to change the conclusions of this paper, a more complete model of equity prices around monetary policy announcements (such as a dividend discount model) would be useful in better understanding how monetary policy propagates through equity markets.

Footnote

In the Australian context, Kirchner (2020) shows that tightening of monetary policy leads to decreases in consumer confidence and has no discernible effect on business confidence – which suggests that the information effect does not seem to be having a strong influence in these domains either. [15]