The stock market's reaction to changes in the federal funds target rate

Journal of International Business and Economics, May, 2007 by E.M. Ekanayake, Robin Rance, Mihalis Halkides

ABSTRACT

This paper examines the stock price reaction of individual stocks listed in the Dow Jones Industrial Average (DJIA) to Federal Funds target rate change announcements using daily stock returns over the period from January 2, 1996 to May 25, 2007. We measure such reactions using an event-study methodology to analyze the impact of changes in the Federal Funds target rate on individual stock returns using several event windows. Results indicate that, on average, the impact of a Federal Funds target rate decrease on stocks is positive while the reaction of a Federal Funds target rate increase is negative. The results also indicate that the stock market reaction depends on the industry sector.

Keywords: Event-study methodology, stack market reaction, federal funds target rate.

1. INTRODUCTION

This study investigates the effects of Federal Funds target rate changes on the stock performance of 30 companies listed in the Dow Jones Industrial Average (DJIA) over the period from January 2, 1996 to May 25, 2007. Using an event-study framework, this study examines how the stock market responds to the expected financial performance of the firm at the announcement of Federal Funds target rate changes.

According to Rigobon and Sack (2002), the relationship between Federal Funds target rate changes and stock prices is an important topic for both monetary policy makers and financial market participants. From the perspective of monetary policymakers, having reliable estimates of the reaction of asset prices to the policy instrument is a critical step in formulating effective policy decisions. Much of the transmission of monetary policy comes through the influence of short-term interest rates on other asset prices, as it is the movements in these other asset prices including longer term interest rates and stock prices that determine private borrowing costs and changes in wealth, which in turn importantly influence real economic activity. From the perspective of financial market participants, monetary policy has a considerable influence on financial markets, as evidenced by the extensive attention that the Federal Reserve receives in the financial press. Thus, having accurate estimates of the responsiveness of asset prices to monetary policy is an important component of making effective investment decisions and formulating appropriate risk management strategies.

Figure 1 shows the relationship between the Federal Funds target rate and the stock prices of the 30 companies listed in the Dow Jones Industrial Average (DJIA) over the years 1996 though 2007. It is not easy to identify any specific relationship between the Federal Funds target rate and the stock prices from Figure 1, although the correlation coefficient between the two variables is mostly negative and low.

As Bernanke (2003) points out, there are two essentially equivalent ways of understanding why expectations of higher short-term real interest rates should lower stock prices. First, to value future dividends, an investor must discount them back to the present value; as higher interest rates make a given future dividend less valuable in today's dollars, higher interest rates reduce the value of a share of stock. Second, higher real interest rates make investments other than stocks, such as bonds, more attractive, raising the required return on stocks and reducing what investors are willing to pay for them. Under either interpretation, expectations of higher real interest rates are bad news for stocks.

According to Rigobon and Sack (2002), there are two considerations that complicate the identification of the responsiveness of asset prices to monetary policy. First, short-term interest rates are simultaneously influenced by movements in asset prices, resulting in a difficult endogeneity problem. Second, a number of other variables, including news about the economic outlook, likely have an impact on both short-term interest rates and asset prices. Despite these difficulties, this study attempts to identify the reaction of stock prices to changes in monetary policy.

The remainder of the paper is organized as follows: Section 2 provides a review of the existing literature on this topic. Section 3 gives a brief description of the event-study methodology. Section 4 outlines the data used and data sources. Section 5 discusses our analysis and findings while Section 6 offers some conclusions.

2. LITERATURE REVIEW

Relatively few papers to date have attempted to measure the equity market's reaction to monetary policy. Among recent papers exploring asset price responses to monetary policy actions--as proxied by changes in the target Federal Funds rate--are Bernanke and Kuttner (2005), Bernanke (2003), Bomfim (2003), Bomfim and Reinhart (2000), Kuttner (2000), Roley and Sellon (1998), Thornton (1998), and Reinhart and Simin (1997). Chen et al. (1999) also examined monetary policy effects on stock market volatility, by studying the effect of discount rate decisions on stock market volatility. Previously, Castanias (1979) had also examined the relationship between discount rate decisions and the volatility of stock returns.