RDP 2021-04: Monetary Policy, Equity Markets and the Information Effect 5. Results

5.1 ASX 200

I present the estimated response of the ASX 200 index to a 100 basis point contractionary monetary policy surprise. All results are symmetric unless stated otherwise, so the opposite result would occur to a 100 basis point monetary policy easing.

Consistent with standard models, unexpected increases in the cash rate cause equity prices to fall (Figure 3). The estimates suggests that a 100 basis point increase in the OIS curve drives around a 3 per cent decline in the ASX 200 index. This result is significant at all conventional levels.

The results also highlight the upward bias present when using the cash rate change instead of the monetary policy surprises. The absolute value of the effect is much smaller when using the cash rate as the independent variable. Indeed it is around zero (at 0.04) and statistically indistinguishable from zero, indicating the ASX 200 on average does not respond in real time to changes in the cash rate. This is likely because changes in the cash rate are predictable and mostly already incorporated into the ASX 200 price prior to the monetary policy announcement.

The estimated results are consistent in sign with studies from the United States such as Bernanke and Kuttner (2005) and Bauer and Swanson (2019). However, the estimates appear to be smaller in Australia than the United States, which are estimated to be around 3 to 8 per cent. But the estimates do closely align with findings using Australian data (Chapman 2014; Brown and Karpavičius 2017).^[9]

Despite the result, it is hard to disentangle the underlying driver of the equity price response. This is because equity prices are driven by changes in expected earnings, the zero coupon rate and premia as represented in Equation (2). We know changes in monetary policy move the zero coupon rate in the same direction, but the effects on expected earnings and premia are ambiguous. This makes generating inference from only equity prices difficult. Nonetheless, the results still suggest that, at the very least, the information effect of monetary policy does not dominate the response of equity prices. Instead, an unexpected tightening in monetary policy has the standard contractionary effect on equity prices.

5.2 Earnings forecasts

To disentangle the mechanism behind the response of equity prices, I estimate the response of earnings growth forecasts to the monetary policy surprises. To do this I take the weekly revisions of the ASX 200 earnings growth forecasts (one-year-ahead and ‘long-term’) around the monetary policy decisions as the dependent variable in Equation (3).^[10] If the information effect operated through earnings expectations we would expect a positive response of forecasted earnings to a monetary tightening.

The results show that a tightening of monetary policy has a negative and significant effect on the one-year-ahead forecast of ASX earnings growth (Figure 4). For the one-year-ahead forecast, a 100 basis point increase in the OIS curve causes expected earnings growth of the ASX 200 to fall by 1.9 percentage points. The results for long-term earnings growth are less clear, with a monetary policy surprise having a small and statistically insignificant effect on forecasted ASX 200 earnings growth. This is unsurprising given that it is unclear whether monetary policy has any long-term – as opposed to cyclical – effects, and the fact that longer-term expectations of earnings growth are likely pinned down by a range of other factors outside the control of monetary policy, such as technology and population growth.

Similar to the results in Section 5.1, using the cash rate as the independent variable instead of the monetary policy surprise has large effects on the results. The sign of the estimated response of earnings revisions for both forecast horizons becomes positive, suggesting that cash rate increases cause upward revisions to ASX 200 growth forecasts. This likely reflects cash rate changes being a response to known information that also affect earnings growth forecasts.

Overall, I find little evidence that the information effect is present in the earnings component of the ASX 200. Rather the results suggest that earnings are one of the drivers behind the negative ASX 200 response to tighter monetary policy found in Section 5.1. This illustrates that any information effect of monetary policy is not being masked by changes in the discount factor of equity prices. That is, the response of the ASX 200 to an unexpected monetary policy tightening is a function of both an increase in the discount rate (from a higher zero coupon rate) and a decline in earnings growth expectations. Overall, the results support the conventional view that equity markets interpret a monetary policy tightening as contractionary for economic activity.

Footnotes

In general, the literature estimate the semi-elasticity of monetary policy surprises on equity prices. A comparison between the elasticity and semi-elasticity is presented in Appendix C. [9]

It is unclear what the precise definition of ‘long-term’ is. Some internal analysis at the RBA suggests that it is a decent approximation of the 3 to 5-year growth rate. [10]