Asset Returns, Discount Rate Changes, and Market Efficiency

Abstract

The primary purpose of this paper is to reconcile the previous findings of discount rate endogeneity with the presence of discount rate announcement effects in securities markets. The crux of this reconciliation is the distinction between “technical” discount rate changes that are endogenous and “nontechnical” changes which contain some informative policy implications. In essence, we attempt to separate expected discount rate changes from unexpected changes, or equivalently, the expected component of discount rate changes from the unexpected component. If markets are efficient, the former should have no announcement effects while the latter may be associated with an announcement effect. Accordingly, the focus of the empirical analysis is on the interaction between discount rate exogeneity, the specific monetary policy regime, and accouncement effects. In addition, we examine whether the behavior of these markets in the postannouncement period is consistent with the rapid price adjustment implied by market efficiency.

Stock prices, firm size, and changes in the federal funds rate target

“…Early authors, e.g., Smirlock and Yawitz (1985), find that stock prices respond only to unexpected changes in monetary policy and we confirm their result in this paper. Therefore, using raw target changes might bias the slope estimate in equation 1 .…”

“…Also, it is not clear why inflation has asymmetric effects on stocks of different sizes. 3 Smirlock and Yawitz (1985), among many others, also find that stock market indices responded significantly to unexpected changes in monetary policy instruments such as discount rates, but not expected ones.…”

Effect of Federal Reserve Policies on Bank Equity Returns

“…Roley and Troll (1984) find no announcement effect from discount rate changes on the term structure of interest rates from September 1977 to October 1979. Smirlock and Yawitz (1985) find that discount rate announcements did not affect market interest rates or stock prices. Yet, Cook and Hahn (1988) find that nontechnical discount rate announcements affected market interest rates from 1973 to 1985.…”

“…Similar deliberations motivate Hafer (1986) to state that movements in the federal funds rate directly convey information about changes in policy objectives, rendering any information contained in discount rate changes redundant during the pre‐1979 (interest rate targeting) period. Moreover, Smirlock and Yawitz (1985) state that discount rate changes will not by themselves change the level of market interest rates in periods of federal funds rate targeting, regardless of whether the discount rate change is a technical or a nontechnical one.…”

The effect of monetary policy shocks on stock prices accounting for endogeneity and omitted variable biases

“…66See Pearce and Roley (1985), Smirlock and Yawitz (1985), Chen et al (1999), Kuttner (2001), Lobo (2002) and Bernanke and Kuttner (2005).…”