RDP 2021-04: Monetary Policy, Equity Markets and the Information Effect 1. Introduction

The ‘information effect’ occurs if monetary policy actions reveal new information to agents about the state of the economy. For example, if the central bank unexpectedly raises interest rates, individuals could infer that the central bank has information about stronger future economic growth that they do not have. This might have positive real effects as agents act on this new information by consuming and investing more. Hence, the predictions of the information effect can run counter to conventional macroeconomic models, where interest rate increases reduce economic activity.

The existence of the information effect could potentially alter the optimal monetary policy prescription. For example, if the conventional effects of cash rate changes (e.g. exchange rate and cash flow channel) are partially offset by the information effect, then monetary policy may need to be more aggressive in offsetting any given demand shock. Taking this further, if the information effect were consistently larger than all other monetary policy effects, then the monetary policy prescription would actually be the reverse of what conventional wisdom dictates. Indeed, concerns about the existence of the information effect have been raised by market economists and media commentary in Australia (e.g. Kehoe 2019).

The information effect is often premised on the central bank acting on a superior information set relative to other economic agents. This superior information could arise from the resources that central banks devote to analysing and forecasting the economy. In Australia, the Reserve Bank of Australia (RBA) employs just under 400 people in ‘core policy’ functions (RBA 2020); excluding staff involved in payments system work and various support functions within the policy areas, around 170 staff are directly involved in monitoring and forecasting economic and financial developments and implementing monetary policy decisions. This headcount is likely far more than any private sector organisation employs for monitoring the Australian economy. As a result, the RBA's assessment of the economy could be of higher quality than any other individual organisation's assessment.^[1] A similar observation has also been made for the Federal Reserve in the United States:

... the Federal Reserve commits far more resources to forecasting than even the largest commercial forecasters. As a result, it is able to produce superior forecasts from publicly available information (Romer and Romer 2000, p 437)

In this paper, I examine whether the information effect of monetary policy exists in Australia using the lens of equity markets. Specifically, I estimate the effect of surprise changes in monetary policy on equity prices and forecasts of equity earnings growth. If monetary policy actions contained additional information about the economy and the information effect dominated, we would expect agents to upwardly revise their equity earnings forecasts and – if the earnings revision was large enough – equity prices to increase in response to a surprise tightening of monetary policy, and vice versa. Meanwhile, standard models of monetary policy would predict the opposite; a surprise tightening of monetary policy would cause equity prices to fall as agents downwardly revise their earnings forecasts. To my knowledge, this is the first paper that combines both equity prices and equity earnings growth forecasts to explore the information effect of monetary policy.

Measuring the effects of monetary policy is inherently difficult. The RBA's actions are not random, rather they are in response to the prevailing and expected economic conditions at the time. This presents a challenge for empirical analysis as agents are often able to predict monetary policy prior to the announcement and adjust their actions accordingly. Hence, if a particular monetary policy announcement were predicted perfectly there should be no observable change following the announcement. To overcome this issue I use high-frequency financial data of Australia's overnight index swap (OIS) market, which measures expectations of the cash rate. Taking OIS pricing around the window of monetary policy announcements effectively isolates the ‘unexpected’ or ‘surprise’ component of the monetary policy announcement and allows for direct analysis of the effect of this unexpected component of monetary policy. This methodology was pioneered by Cook and Hahn (1989), Kuttner (2001) and Cochrane and Piazzesi (2002), and then furthered by Gürkaynak, Sack and Swanson (2005).

I find little evidence that the information effect is an important or strong channel in these markets. Instead, the results support the conventional understanding of monetary policy channels: a monetary tightening causes equity prices to fall and earnings forecasts to be revised down. In response to a 100 basis point contractionary monetary policy surprise, I estimate that the ASX 200 index declines by around 3 per cent. One-year-ahead ASX 200 earnings growth forecasts also fall by 1.9 percentage points following the same monetary policy tightening. This suggests that the decline in equity prices following a monetary policy tightening is, at least in part, driven by downward revisions in expected earnings.

The main focus of this paper, and most of the literature, is on monetary policy announcements. Looking beyond monetary policy announcements, however, provides a more nuanced view of the information effect. Central bank communication via speeches and publications has become an important element of the monetary policy toolkit and may contain more information content than monetary policy announcements (Cieslak and Schrimpf 2019). I find some evidence that monetary policy surprises generated from RBA Governor speeches produce responses in equity prices and forecasted earnings consistent with the information effect. However, the evidence I find suggests that these responses could also reflect the speech communicating changes in the policy reaction function rather than information about the economic outlook.

Monetary policy surprises can be decomposed into three components: changes to the policy reaction function, changes in underlying economic data (information) that policy responds to, and deviations from the reaction function. This raises the question: what do ‘surprise’ monetary policy moves signal? The equity market responses to monetary policy surprises suggest changes in information are not the primary driver of these surprises. One possibility is that the results are driven by ‘random’ deviations from a policy rule. Alternatively, they might reflect either an update to or new information about the – generally unobservable – policy reaction function that surprises market participants.

To answer this I directly test if changes in the policy reaction function can be detected. If the release of economic news could predict the monetary policy surprises this would imply that the RBA has been systematically changing its policy reaction function in response to certain economic news. I test this by examining the relationship between the monetary policy surprises and surprises in economic news, in particular GDP, inflation and unemployment. I find little evidence that surprises in these economic releases can predict the monetary policy surprises, suggesting that the monetary policy reaction function has not consistently changed to incoming economic news. This provides tentative evidence that the ‘surprise’ monetary policy changes are likely better interpreted as being driven by ‘random’ deviations from a policy rule than by systematic changes in the policy reaction function (or, as noted above, the information effect). However, more work needs be done to establish this relationship as the monetary policy surprises could still reflect changes in the reaction function to economic news not included in the regressions.

One limitation of my work is that I only focus on the equity market. However, equity markets may not be representative of the expectations of households and businesses in the Australian economy, and so RBA policy changes may still provide information to them. Moreover, as Australian monetary policy heads towards the zero lower bound it is possible that, through forward guidance, monetary policy announcements could convey relatively more information than before. Notwithstanding this, the results show that historically the information effect of monetary policy has not been an important factor in the transmission of monetary policy to Australian equity markets. And conventional interpretations of monetary policy are likely more informative.

The argument in support of these conclusions proceeds as follows. Section 2 outlines a framework that shows how equity price and earnings growth responses to monetary policy can facilitate the identification of the underlying cause of monetary policy actions. Section 3 reviews previous research on this topic, which has produced mixed evidence for the information effect channel. Section 4 outlines the data and method used in this paper to construct monetary policy surprises and the econometric framework used to evaluate the effects of monetary policy on equity prices and earnings growth forecasts. Section 5 outlines the main results of the research and Section 6 explores the appropriate interpretation of the results. I then conduct the same analysis in Section 7 using a broader definition of monetary policy surprises that includes other RBA communication such as speeches from the Governor, Board minutes, and the release of the Statement on Monetary Policy (SMP). Section 8 applies various robustness tests to the main results. Section 9 discusses the results and Section 10 concludes.

Footnote

Though it is likely that the RBA's assessment is of higher quality than any individual organisation's assessment, previous research has shown aggregated market forecasts have produced superior GDP forecasts to the RBA. However, the RBA has outperformed the same aggregated market forecasts for CPI inflation (Tulip and Wallace 2012). [1]