RDP 2021-04: Monetary Policy, Equity Markets and the Information Effect 6. Policy Rule Changes or Deviations?

The results suggest that the information effect is not a strong channel of monetary policy in Australian equity markets. However, it remains unclear whether the monetary policy surprises identified reflect deviations from a policy rule $({\epsilon }_t)$ or changes in the policy rule (f_t (·)). Bauer and Swanson (2019), for example, provide evidence that the results in work finding support for the information effect in the United States (Campbell et al 2012; Nakamura and Steinsson 2018) can be better explained by the Federal Reserve becoming progressively more responsive to economic news.

To evaluate if the ‘surprises’ should be interpreted as policy rule changes or deviations, I test if the policy reaction function has changed systematically over the sample. One way to do this is to determine if the constructed monetary policy surprises can be explained by economic news known at the time. If economic news has a statistically significant relationship with the identified monetary policy surprises, this would suggest that the RBA has consistently changed its policy reaction rule to economic news and market participants have lagged behind in updating their estimate of the central bank reaction function as they observe monetary policy changes.^[11] I estimate the following equation, which is similar to the approach adopted by Bauer and Swanson (2019).

where:

• F_1,t is the first factor from Equation (3), scaled to the one month OIS contract. Only the observations immediately following the release of economic news are used.
• economic news_t represents the unexpected component of an economic release. To measure economic news I take the difference between the first release of actual GDP growth, CPI inflation and the unemployment rate from the ABS against the average forecasts from the Bloomberg survey of market economists.^[12]
• ${\gamma }_0$ is a constant and ${\xi }_t$ is the error term.

I find little evidence that the constructed measure of monetary policy surprises can be explained by the economic news included here. The confidence intervals for these economic releases include zero, indicating that market participants have not consistently been surprised by changes by the RBA to its policy reaction function to any of the economic variables over time (Figure 5).

The estimate for the unemployment rate is only marginally insignificant (at the 10 per cent level). Interpreting the point estimate suggests that the RBA may have become less responsive to surprise increases in the unemployment rate. Nonetheless, it is unlikely this could explain all of the response in equity prices and earnings forecasts given the uncertainty of this estimate.

The results provide little evidence that the monetary policy surprise series can be predicted by unemployment, GDP or inflation news. This lends some evidence to the responses from the baseline information effect regressions being the result of deviations from a policy rule, rather than from changes in the policy rule itself. However, it is possible that the measured monetary policy ‘surprises’ include policy reactions to variables not included in these regressions. Moreover, the results should not be interpreted as saying that the monetary policy reaction function has been stable over the sample. They only show that on average over the sample, economic news (defined as GDP, CPI inflation and unemployment) has not resulted in consistent surprise changes in the policy reaction function. It is still possible that there have been changes in the reaction function. For example, if the reaction function changed but this was announced or well communicated ahead of the actual policy decision, this would not be captured by these regressions.

Footnotes

An alternative explanation would be that the monetary policy surprises are not exogenous and have not incorporated all known information. [11]

All data are seasonally adjusted. [12]