By using data from the federal funds futures market, then, it is
possible to estimate the value at which financial market participants
expect the FOMC to set its target for the federal funds rate on any
given date. By comparing this expected value to what the FOMC
actually did at each date, we can determine the portion of the Fed's
interest rate decision that came as a surprise to financial markets.
In our research, Kuttner and I considered all the dates of scheduled
FOMC meetings plus all the dates on which the FOMC changed the
federal funds rate between meetings, or made intermeeting moves, for
the period May 1989 through December 2002, amounting to a total of
131 observations.4 For each of these dates, we used the expected
value of the federal funds rate as inferred from the futures market
to divide the actual change in the federal funds rate on that day
into the part that was anticipated by the markets and the part that
was unanticipated.5 So, for example, on November 6, 2002, the Federal
Reserve cut the federal funds rate by 50 basis points. (A basis point
equals 1/100 of a percentage point, so a 50-basis-point cut equals a
cut of 1/2 percentage point.) However, this cut in the federal funds
rate was not entirely unexpected; indeed, according to the federal
funds futures market, investors were expecting a cut of about 31
basis points, on average, from the Fed at that meeting.6 So, of the
50 basis points that the FOMC lowered its target for the federal
funds rate last November 6, only 19 basis points were a surprise to
financial markets and thus should have been expected to affect asset
prices. Note, by the way, that if the Fed had not changed interest
rates at all that day, our method would have treated that action as
the equivalent of a surprise tightening of policy of 31 basis points
because the Fed would have done nothing while the market was
expecting an easing of 31 basis points.
To evaluate the effect of monetary policy on the stock market, we
looked at how broad measures of stock prices moved on days on which
the Fed made unanticipated changes to policy. I can illustrate our
method by continuing the example of the Fed's cut in the federal
funds rate last November 6. On that day, the broad stock market index
we used in our study (the value-weighted index constructed by the
Center for Research in Securities Prices at the University of
Chicago) rose in value by 0.96 percentage point. Dividing the 96-
basis-point gain in the stock market by the 19-basis-point downward
surprise in the funds rate, we obtain a value of approximately 5 for
the "stock price multiplier" relating policy changes to stock market
changes. If this one day were representative, we would conclude that
each basis point of surprise monetary easing leads to about a 5-basis-
point increase in the value of stocks. Or, choosing magnitudes that
might be more helpful to the intuition, we could just as well say
that a surprise cut of 25 basis points in the federal funds rate
should lead the stock market to rise, on the same day, about 1.25
percentage points--about 120 points on the Dow Jones index at its
current value. In fact, applying a formal regression analysis to the
full sample from 1989 to 2002, we found a number fairly close to this
one, namely, a stock price multiplier for monetary policy of about
4.7. We also found, as expected, that changes in monetary policy that
were anticipated by the market had small and statistically
unimportant effects on stock prices, presumably because these changes
had already been priced into stocks.7
Although a stock price multiplier of about five for unanticipated
changes in the federal funds rate is certainly not negligible, we
should appreciate that unexpected changes in monetary policy account
for a tiny portion of the overall variability of the stock market.
Unanticipated movements in the federal funds rate of 20 basis points
or more are relatively rare (we observed only thirteen examples in
our fourteen-year sample). Yet the change of one percent or so in the
stock market induced by the typical 20-basis-point "surprise" in the
funds rate is swamped by the overall variability of stock prices. For
example, over the past five years, the broad stock market has moved
one percent or more on about 40 percent of all trading days. Thus,
news about monetary policy contributes very little to the day-to-day
fluctuations in stock prices.
We explored our empirical results with some care. We noted, for
example, that a few of the monetary policy changes in our sample were
followed by what seemed to be excessive or otherwise unusual stock
market responses. A number of these responses occurred rather
recently, during the Fed's series of rate cuts in 2001. The Fed's
surprise intermeeting cuts of 50 basis points each on January 3 and
April 18 of that year were both greeted euphorically by the stock
market, with one-day increases in stock values of 5.3 percent and 4.0
percent, respectively. By contrast, the rate cut of 50 basis points
on March 20, 2001, was received less enthusiastically. Even though
the cut was more or less what the futures market had been
anticipating, the financial press reported that many equity market
participants were "disappointed" that the rate cut hadn't been an
even larger 75-basis-point action. In any event, the market lost more
than 2 percent that day. |
