RDP 2021-04: Monetary Policy, Equity Markets and the Information Effect 2. The Information Effect and Equity Prices

To better understand the information effect, it is useful to decompose changes to the nominal short-term interest rate, which the central bank controls (the cash rate in Australia), into its various components. Changes in the cash rate could reflect ‘random’ deviations from the policy reaction function, changes in the reaction function itself, or changes in the outlook of macroeconomic variables used to guide policy, such as unemployment and inflation. More formally, the nominal interest rate, i_t , set by the central bank can be represented as:

where:

• t is a time index
• f_t (·) represents the (unobservable) monetary policy reaction function, which can vary over time
• X_t represents the (observable and unobservable) information set that the interest rate decision is based on, this could include, for example, the central bank's own economic forecasts
• ${\epsilon }_t$ represents a deviation from the monetary policy reaction function.

The information effect of monetary policy would occur if changes to the nominal interest rate were interpreted by market participants as driven by changes in the information set, X_t, that are only observable to the central bank (the ‘unobservable’ component). However, only the change in the nominal interest rate, i_t, is directly observable, whereas changes in its determinants ( f_t (·), X_t or ${\epsilon }_t$ ) are not. In fact, at any point in time, all 3 factors may explain part of the interest rate change made by the central bank.

To draw inference about the information effect, I aim to identify the relative importance of these 3 factors based on the direction of the responses of equity prices and their determinants to surprise changes in the nominal rate. For this, it is useful to consider how equity prices are determined.

The price of equities can be expressed as the expected present discounted value of future dividends, as follows:

where:

• P_t is the equity price at time t
• E is the expectations operator
• D represents equity earnings (dividends or buybacks)
• R represents the relevant discount rate for equities; this includes the zero coupon (or risk-free) rate, term premia and the equity risk premium.

This framework demonstrates that changes in equity prices could reflect changes in earnings, risk-free rates or risk premia. To infer the relevance of the information effect from other interpretations of changes in the nominal rate, it is useful to consider how each of the interpretations of a change in the nominal policy rate moves the individual determinants of equity prices.

These predictions are presented in Table 1. Changes in the cash rate unambiguously move the zero coupon rate in the same direction, but the effect on expected earnings depends on what market participants believe is the driver of a cash rate change.^[2] If market participants concluded that the primary driver behind an increase in i_t was the central bank having received a private, positive signal about the state of the economy (a revision in X_t ) and this caused participants to update their view on the economic outlook, we would expect forecasted earnings to increase and, if the earnings effect was large enough, equity prices to increase.^[3] These responses would be indicative of an information effect. If the increase in i_t is viewed as an unusually strong policy tightening for a given information set (a deviation from the policy rule, ${\epsilon }_t$) the opposite response would be expected (equity prices and forecasted earnings would decrease); this is the response that standard macroeconomic models would predict. Lastly, if a change in the nominal interest rate, i_t, causes market participants to update their perception of the policy reaction function, f_t (·), this could lead to a variety of different results based on how the change is perceived.

It is worth emphasising that the predictions are based on how market participants interpret the changes in monetary policy. And that these interpretations may not resemble the true reason for the changes in monetary policy. For example, interest rates may increase because the central bank reacts to information that market participants had not previously realised could be important (i.e. a change in the policy reaction function). But if market participants interpret the increase as occurring because the central bank has upgraded its economic outlook, this would produce responses consistent with the information effect. In this case, we would still be able to conclude that the information effect of monetary policy is present even if the true underlying reason for interest rate change is unrelated to new economic data. This would, however, raise questions about how long this misunderstanding could persist and whether the resulting reactions were temporary or permanent. This is not a question I pursue in this paper; instead I only focus on short-term responses.

In this paper, I use the predictions in Table 1 to evaluate the relative importance of the information effect channel ( X_t ). Firstly, I evaluate the response of equity prices to changes in monetary policy. Though equity prices provide a useful starting point in determining which components of equity prices dominate, cleanly disentangling all the drivers of equity prices, including risk premia, would be difficult. I therefore also evaluate the response of forecasted earnings growth to changes in monetary policy to disentangle the numerator in Equation (2) and evaluate if the response of expected earnings is consistent with the change in equity prices. This leads to a more complete analysis of the information effect in the context of equity markets.

Though the responses of equity prices and earnings forecasts to monetary policy are useful in potentially identifying an information effect, I would still be unable to uniquely identify the underlying reason for the responses. This is because equity market responses to reaction function changes depend on how the changes are interpreted by the market. For example, suppose monetary policy became increasingly responsive to certain economic news, such as the unemployment rate, over the sample. That is, the central bank raises interest rates more aggressively in response to positive economic news and cuts more aggressively in response to bad news. If equity market participants interpreted this change in the reaction function as an improvement in how the monetary policy regime contributes to economic stability, we could potentially observe equity prices and earnings expectations increasing to interest rate increases, which could be conflated with an information effect.

Though the effect of reaction function changes are ambiguous, an important first step is to determine if the reaction function has changed. One way to do this, and the method taken in this paper, is to examine if the measure of monetary policy surprises used can be predicted by surprises in economic data. If the release of economic news has predictive power for the monetary policy surprises, this would suggest that the monetary policy reaction function has consistently changed its response to economic news.

Footnotes

For simplicity, I am abstracting from risk premia. In reality, the response of risk premia to monetary policy would be ambiguous regardless of the reason for the change in the nominal interest rate. [2]

In theory, the effect of changes in interest rates driven by revisions in information on equity prices is ambiguous. This is because interest rates affect both the earnings component and the discount factor of equity prices. However, the literature has pointed to the response of equity prices as evidence of an information effect (e.g. Cieslak and Schrimpf 2019; Jarocinski and Karadi 2020). That is, the literature assumes that if equity price responses are consistent with an information effect it is a sufficient condition to identify the information effect channel. [3]