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

Finally, Bomfim examined the effects of pre-announcement of monetary policy on the stock market. Results of his study suggest that the stock market is relatively quiet on days preceding the FOMC announcement of its monetary policy (FFTR). He also studied how the actual FOMC interest rate decisions affected stock market volatility. He reports in his paper that surprise elements related to monetary policy announcements increased stock market volatility in the short run and that positive surprises (defined as higher than expected target fed funds rates) tended to have a greater effect on volatility (Bomfim, 2003).

Bomfim concludes his paper with suggestions for further study, including analyzing the market's response to scheduled and unscheduled announcements. Another issue he suggested was whether "the corresponding impulse response functions for volatility are significantly different" (Bomfim, 2003; see also Li and Engle, 1998). Importantly, he suggests that the issue of the impact of pre-announcement on the stock market is ripe for study by the market microstructure researcher.

3. THE FUTURES ON THE FFTR

3.1 Specific Background Research for This Study

As indicated above, in order to measure the impact of monetary policy on asset prices, several approached have been adopted by researchers. In 2000, Poole and Rasche used the 1-month-out federal funds futures contract (Poole and Rasche, 2000; see also Bomfin, 2002). Use the 1-month-out federal funds futures contract, and. In 2001, Kuttner, as well as Faust, Swanson, and Wright, used the current-month federal funds futures contract in their studies of monetary policy's impact on markets (Kuttner, 2001 and Faust, Swanson, and Wright, 2001); however, Rigobon and Sack used the three-month Eurodollar futures rate (Rigobon and Sack, 2002). Clearly, since 1994 the federal funds futures rates or FFTR Futures dominate all other market interest rates for predicting changes in the federal funds rate over horizons several months out. Our research follows a similar approach.

3.2 Federal Futures Rates and Market Expectations

In this study of the movement of the CRSP Value-Weighted Index on the days before and after the event (announcement of FOMC policy), we have chosen to follow Kuttner's approach and use the current-month fed funds futures prices to measure expected and unexpected changes in fed funds rate. The Chicago Board of Trade (CBOT) began trading federal funds futures contracts in October of 1988. The federal funds futures contract is based on the arithmetic average of the daily effective federal funds rate during the month of the contract. The effective federal funds rate is a weighted average of all federal funds transactions for a group of federal funds brokers who report to the Federal Reserve Bank of New York each day. The CBOT offers contracts ranging from the current month to 24 months out. The settlement price in these contracts is equal to 100 minus the average of the effective federal funds rate for the month of the contract.