Does the stock market under-react to the Federal Reserve bank's monetary policy actions?

Review of Business Research, March, 2008 by Levon Goukasian, L. Keith Whitney

ABSTRACT

This paper analyzes the reaction of the stock market to the monetary policy actions of the Federal Reserve (Fed). Specifically, we examine the reaction of the stock market to the monetary policy announcements by the Federal Open Market Committee (FOMC) of the Fed. We show that the full information conveyed by the Fed is not immediately incorporated in asset prices and that there is a statistically significant abnormal return to a broad market index on the day after the announcement by the FOMC of its monetary policy actions. We use data from the federal funds futures market to measure the expected and unexpected changes in the federal funds rate. We demonstrate that the market reacts to the unexpected changes in monetary policy of the FOMC. We detect positive and statistically significant abnormal market returns on the day after the FOMC makes its monetary policy announcements. We reject the hypothesis that these returns are unpredictable by finding predictable returns the day following the day of the FOMC announcement of its monetary policy actions.

Key Words: Efficient Markets Hypothesis (EMH), Abnormal Returns, Under-reaction, Monetary Policy, Fed Funds Futures

1. INTRODUCTION

1.1 Historical Context

For a long time, academic researchers, securities market participants, and policy makers have been interested in how financial asset prices adjust to new information, including information related to the policy announcements of the Federal Open Market Committee (FOMC) of the Federal Reserve (Fed). In spite of the fact that various researchers have established a long list of anomalies, which suggest some predictability in financial markets, most scholars and textbook authors in finance and economics are inclined to believe that financial asset prices are either very difficult or impossible to predict. Their faith in efficient markets (the Efficient Market Hypothesis or EMH) remains strong despite this growing body of literature regarding irrational behavior by investors, anomalies in the markets, and predictability of returns--all of which would seem to merit a rejection of the EMH. For example, one study (DeBondt and Thaler, 1985) detects over-reaction in markets, while other studies (Michaely et. al., 1995 and Bernard and Thomas, 1989) detect market under-reactions. Many other anomalies, such as size effect and momentum effect, are now established in the literature.

1.2 Additional Studies

Still other studies offer a more extensive description of these anomalies and their persistence (Jegadeesh and Titman,1993 and 2001, as well as Schwert, 2001). Additional studies that demonstrate market anomalies include (but are not limited to) the following:

* Studies of market reaction to earnings announcements (Mendenhall, 1991 and Abarbanell and Bernard 1992);

* Studies of stock splits (Grinblatt, Masulis, and Sheridan, 1984 and Desai and Prem, 1997);

* Evaluations of tender offers (Ikemberry and Stice, 1996);

* Examinations of post-event abnormal returns related to extreme, 1-day stock price changes for stocks of U.S. companies (Akhigbe, Gosnell and Harikumar,1998;, Atkins and Dyl, 1990; Bremer and Sweeney, 1991; Brown, Harlow, and Tinic, 1988; Cox and Peterson, 1994, Howe, 1986; and Peterson, 1995);

* Studies of market repurchases (Lakonishok and Vermaelen, 1990; Ikenberry, Lakonishok, and Varmaelen, 1995);

* Studies of seasonal equity offerings (Groth, Lewellen, Scharbaum, and Lease, 1979; Bjerring, Lakonishok, and Vermaelen, 1983; Elton, Gruber, and Gultekin, 1984; and Womack, 1996);

* Studies of revisions in analysts' recommendations (Lougran and Ritter, 1995; Teoh, Welch, and Wong, 1998);

* Studies of public announcements of insider trades (Seyhun, 1986 and 1988);

* A study of venture capital share distributions (Gomper and Lerner, 2005); and

* A study of headline news and stock market reaction (Chan, 2003).

Schwert's publication of a detailed list of market anomalies detected over the past few decades is perhaps the most informative work for our research (Schwert, 2001). He reviews the persistence of these various anomalies that others have noted and shows that most of them have disappeared over time. After these anomalies are detected and disclosed to market participants, market participants take actions that apparently eliminate the anomalies and end the investor's ability to earn abnormal returns. Thus, this result has often been described as the long-term efficiency of the markets.

1.3 Prevailing Views

The common understanding of market efficiency defines financial markets as efficient when prices react speedily and properly to newly available information (Fama, 1970 and 1991). Eugene Fama's summary generally categorizes market efficiency hypotheses as weak form (efficient with regard to all past information), semi-strong form (efficient with regard to all currently available information as well as past information), and strong form (efficient with regard to insider information as well, the one hypothesis rejected even by the faithful). The general idea behind the EMH is that asset prices are determined by the underlying supply and demand for securities offered in a competitive market populated with rational investors who gather all relevant information very rapidly and act immediately upon the information by buying or selling the appropriate financial asset. The actions of such rational investors lead to the right, though unpredictable price. If, in this world of efficient markets, information is immediately incorporated into prices, then only new information (news) should cause changes in prices. Since news is unpredictable, price changes should also be unpredictable. This analysis led to the prevailing belief, especially among academics, that stock prices follow a so-called "random walk," and the best prediction of next year's stock price is today's price plus an unpredictable drift term.