Target Interest Rate News Effects on the Asia Pacific Financ
Transcript of Target Interest Rate News Effects on the Asia Pacific Financ
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TARGET INTEREST RATE NEWS EFFECTS ON
THE ASIA PACIFIC FINANCIAL MARKETS
Do Quoc Tho Nguyen
School of Banking and Finance
The University of New South Wales
A dissertation submitted to the University of New South Wales in fulfillment of the
requirements for the degree of Doctor of Philosophy (PhD)
2009
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ORIGINALITY STATEMENT
I hereby declare that this submission is my own work and to the best of my
knowledge it contains no materials previously published or written by another
person, or substantial proportions of material which have been accepted for the
award of any other degree or diploma at UNSW or any other educational institution,
except where due acknowledgement is made in the thesis. Any contribution made to
the research by others, with whom I have worked at UNSW or elsewhere, is
explicitly acknowledged in the thesis. I also declare that the intellectual content of
this thesis is the product of my own work, except to the extent that assistance from
others in the project's design and conception or in style, presentation and linguistic
expression is acknowledged.
Signed
Date 09/09/2009..............
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ABSTRACT
This thesis is the first study that provides comprehensive empirical evidence
on both the impacts of the target interest rate news from the Reserve Bank of
Australia (RBA) on the Australian financial markets, and the spillover effects of the
target interest rate news from the US Federal Reserves (Fed) and the European
Central Bank (ECB) on the Asia Pacifics equity and currency markets.
This thesis contributes to the current literature in several ways. First, while
there is ample evidence in the literature suggesting that the markets would not react
to what is already expected but will react to the news, the current literature on the
RBAs target rate effects is still limited to the investigation of the overall
announcement impact on the first moment of the Australian market return only.
Therefore, this thesis firstly comprehensively investigates the impacts of the
unexpected components of the RBAs target rate announcements (or news) on the
first two moments of various segments of the Australian financial markets including
interest rate changes, the Australian dollar and stock market returns. In so doing, this
thesis contributes to the current literature on the impacts of domestic target interest
rate news.
Second, while the established literature seems to be missing a thorough
investigation of the spillover effects of the Feds and the ECBs news on the Asia
Pacific markets, this thesis provides comprehensive evidence on the spillover effects
of the Feds and the ECBs target rate news on both the mean and volatility of the
Asia Pacifics stock and currency returns. Furthermore, we not only document the
presence of the news spillover effects but also highlight the incremental explanatory
power of the target interest rate news in the presence of the indirect effects from the
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USs and euro areas markets to the Asia-Pacific markets. To this end, this thesis
contributes to the literature onspillover effects of foreign target interest rate news.
Third, while the literature is silent on how quickly the target interest rate
news is absorbed in foreign markets, this thesis takes a step forward and breaks down
the daily horizon into the overnight and the intraday horizons. In so doing, the thesis
examines the absorption speed of target rate news in the Asia-Pacific markets. This is
an important issue because there might be potential for a diverse array of response
dynamics across countries due to heterogeneous market developments, nature of
monetary policy synchronization, and financial and real integration with the U.S. and
the euro area.
Specifically, this thesis presents three independent empirical inquiries that
contribute to the literature on domestic and spillover effects of the target interest rate
news. Chapter 41 provides comprehensive empirical evidence for the impacts of the
RBAs target rate news on various segments of the Australian financial markets
during the period from 1998 to 2006. We also investigate the spillover effects of the
US Feds news on the Australian financial markets. We show that the RBAs and the
Feds news significantly affect the Australian financial markets in line with a priori
expectations. However, while the RBAs news raises volatility in the Australian
financial markets, the volatility was significantly lower in all market segments
following the Feds news.
1A shorter version of this chapter is published in Research in International Business and Finance,
22(3), pp. 378-395, 2008. It has also received the Best paper award at the 2008 International Business
and Economics Research conference, Nevada, USA.
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The spillover effects of the US Feds and the ECBs target interest rate news
on the mean and the volatility of twelve Asia Pacifics stock markets returns are
examined in Chapter 52
,
and seven Asia Pacific exchange rates against the US dollar
and the euro over the period 1999-2006 are carried out in Chapter 63. The spillover
effects on the conditional mean are generally consistent with the literature where a
majority of Asia Pacific stock markets shows significant negative returns and a
majority of currencies depreciates against the US dollar and the euro in response to
the Feds and the ECBs unexpected rate rises. Furthermore, in response to the two
target rate news, the conditional volatility of the Asia Pacific stock markets was
higher while the market calming effects have been observed for the currency markets
and both the Fed and the ECB news elicit persisting volatility responses. We
conjecture that as the ECBs news tends to confirm the Feds earlier decision, this
relationship might help reduce uncertainties in the Asia Pacific currency markets
upon the future path of target interest rates from both the Central Banks, which
ultimately results in into a lower volatility level.
These findings are important not only to the Asia Pacifics policy makers to
help them improve the conduct of monetary policy but also to market participants in
designing trading mechanisms as well as risk management strategies in response to
both domestic and external interest rate shocks. Furthermore, these findings also shed
2A shorter version of this chapter is published in Journal of International Financial Markets,
Institutions & Money 19 (3), pp. 415-431, 2009.
3A shorter version of this chapter is published in International Research Journal of Finance and
Economics, 20, pp. 27-45, 2008.
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light on the lead-lag relationship between the Fed and the ECB in making policy
decisions. The notion that the ECB follows the Fed in setting its policy is so strong
amongst market participants that empirical evidence seems to be crucial. Despite the
fact that the ECBs news arrives after the Feds news, this study provides evidence
that the ECBs news has its own merits in the Asia Pacific markets and helps resolve
differences in beliefs among market participants.
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ACKNOWLEDGEMENTS
Although only my name appears on the cover of this dissertation, I could
never have reached the heights or explored the depths without the help, support,
guidance and efforts of many people. I owe my gratitude to all those people who
have made this dissertation possible and because of whom my graduate experience
has been one that I will cherish forever.
I would like to gratefully thank my sole supervisor, Associate Professor Suk-
Joong Kim for his guidance, understanding, patience, and most importantly, his co-
authorship attitude instead of supervision during my graduate studies at the
University of New South Wales. His mentorship was paramount in providing a well-
rounded experience consistent with my long-term career goals.
I am also grateful to the guidance and endless support from Associate
Professor Toan Pham as well as fellow research students during my study at the
University of New South Wales. My special thanks also go to my colleagues at the
International Monetary Fund, Raghuram G. Rajan (now at the University of
Chicago), Stijn Claessens, Hali Edison, Susan Adams as well as Carl Hubbard at
Trinity University for valuable comments and suggestions that greatly improve this
thesis works. I would like to thank the examiners, Colm Kearney, Michael
McKenzie and Eliza Wu, for valuable comments and suggestions that greatly
enhance the thesis. I also would like to thank Stephen Ferris, Ali Fatemi, Ruggero
Bertelli and Craig Lewis for giving me opportunities to referee papers submitted to
your journals and Annual Meetings. I also would like to thank AusAID for
generously providing me this second scholarship to pursue this PhD study. I also
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acknowledge financial support from the University of New South Wales for
conference grants.
Finally, and most importantly, I would like to thank my wife Ha Phi. Her
support, encouragement, quiet patience and unwavering love were undeniably the
bedrock upon which the past seven years of my life have been built. Her tolerance of
my occasional vulgar moods is a testament in itself of her unyielding devotion and
love. I thank my son, Ty, for his companion everyday to the University and his
Childcare center as well as sharing with me his childhood overseas. I am also
grateful to my parents and Has parents for their faith in me. This thesis is dedicated
to my family!
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TABLE OF CONTENTS
Page
ABSTRACT ................................................................................................................... iii
ACKNOWLEDGEMENTS ......................................................................................... vii
LIST OF TABLES ........................................................................................................ xii
LIST OF FIGURES ..................................................................................................... xiv
LIST OF ABBREVIATIONS ....................................................................................... xv
LIST OF JOURNAL PUBLICATIONS FROM THE DISSERTATION ............ xviii
CHAPTER 1 -INTRODUCTION ................................................................................. 1
1.1. Objectives of the thesis ........................................................................................ 2
1.2. Contributions to the literature ........................................................................... 4
1.3. Thesis outline ..................................................................................................... 10
CHAPTER 2 -LITERATURE REVIEW OF TARGET RATE NEWS
EFFECTS ............................................................................................................ 12
2.1. The impacts of the central bank target interest rate on domestic
financial markets ........................................................................................................... 13
2.1.1. The debt markets ............................................................................................. 13
2.1.2. Stock markets .................................................................................................. 15
2.1.3. Exchange rates ................................................................................................. 18
2.1.4. The credit channel ........................................................................................... 19
2.2. The spillover effects of foreign target interest rate news ............................... 20
CHAPTER 3 -DATA AND ECONOMETRIC MODELING ISSUES .................... 24
3.1. Central banks target interest rate communications ..................................... 25
3.1.1. The RBAs cash rate target.............................................................................. 25
3.1.2. The U.S. Federal Reserves federal funds target rate ...................................... 27
3.1.3. The European Central Banks main refinancing rate target ............................ 28
3.2. Target interest rate news .................................................................................. 30
3.2.1. The RBAs cash rate news .............................................................................. 31
3.2.2. The Feds and the ECBs target rate news ...................................................... 32
3.3. Econometric methodology ................................................................................ 37
3.3.1. The RBAs effects on the Australians financial markets ............................... 39
3.3.2. The Feds spillover effects on the Australian financial markets ..................... 40
3.3.3. The Feds and the ECBs spillover effects on the Asia Pacific financialmarkets ........................................................................................................................ 41
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CHAPTER 4 -THE REACTION OF THE AUSTRALIAN FINANCIAL
MARKETS TO THE INTEREST RATE NEWS FROM THE RESERVE
BANK OF AUSTRALIA AND THE US FED ............................................................ 46
4.1. Introduction ....................................................................................................... 47
4.2. Data ..................................................................................................................... 50
4.2.1. Target interest rate announcement data ........................................................... 50
4.2.2. Target interest rate news .................................................................................. 52
4.2.3. Australian financial market daily returns ........................................................ 55
4.3. Empirical modeling issues ................................................................................ 56
4.3.1. Baseline EGARCH(1,1) model ....................................................................... 56
4.3.2. Overall news effects of the RBAs target interest rate news ........................... 57
4.3.3. Asymmetric effects of the RBAs target rate news ......................................... 60
4.3.4. Spillover effects of the US Feds target interest rate news ............................. 61
4.4. Empirical results ................................................................................................ 63
4.4.1. The baseline EGARCH(1,1) results ................................................................ 63
4.4.2. Overall effect of the RBAs target interest rate news...................................... 67
4.4.3. Asymmetric impacts of the RBAs target interest rate news .......................... 71
4.4.4. Spillover effects of the US Feds target interest rate news ............................. 73
4.4.5. Asymmetric spillover effects of the US Feds target interest rate news ......... 75
4.5. No-news effects .................................................................................................. 75
4.6. Conclusion .......................................................................................................... 76
CHAPTER 5 -THE SPILLOVER EFFECTS OF TARGET INTEREST RATE
NEWS FROM THE US FED AND THE EUROPEAN CENTRAL BANK ON
THE ASIA PACIFIC STOCK MARKETS ................................................................ 85
5.1. Introduction ....................................................................................................... 86
5.2. Data and empirical modeling issues ................................................................. 89
5.2.1. The Asia Pacific stock index returns ............................................................... 89
5.2.2. Empirical modelling ........................................................................................ 94
5.3. Empirical results ................................................................................................ 99
5.3.1. Baseline model results ..................................................................................... 99
5.3.2. The US Feds target interest rate news spillover effects ............................... 100
5.3.3. The ECBs target interest rate news spillover effects ................................... 107
5.4. Robustness checks ........................................................................................... 109
5.4.1. Joint spillover effect of the target interest rate news ..................................... 109
5.4.2. The role of indirect impacts ........................................................................... 1115.4.3. Policy cycle impacts ...................................................................................... 120
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5.4.4. Asymmetric effects ........................................................................................ 121
5.5. Conclusion ........................................................................................................ 129
CHAPTER 6 -TARGET INTEREST RATE NEWS EFFECTS ON THE ASIA
PACIFIC CURRENCY MARKETS ......................................................................... 1316.1. Introduction ..................................................................................................... 132
6.2. Data ................................................................................................................... 134
6.3. Empirical methodology ................................................................................... 136
6.3.1. Baseline EGARCH(1,1) model ..................................................................... 136
6.3.2. Target interest rate news spillover effects ..................................................... 139
6.4. Empirical results .............................................................................................. 141
6.4.1. Baseline models results ................................................................................ 141
6.4.2. The Feds target interest rate news spillover effects ..................................... 146
6.4.3. The ECBs target interest rate news spillover effects ................................... 148
6.5. Robustness checks ........................................................................................... 149
6.5.1. Joint spillover effects of the target interest rate news ................................... 149
6.5.2. Asymmetric effects ........................................................................................ 151
6.5.3. The Feds and the ECBs news effect on the USDEUR pair ........................ 158
6.6. Conclusion ........................................................................................................ 159
CHAPTER 7 -CONCLUSION AND DIRECTIONS FOR FURTHERRESEARCH .......................................................................................................... 161
7.1. Conclusion ........................................................................................................ 162
7.2. Directions for future research ........................................................................ 166
7.2.1. Higher frequency data ................................................................................... 166
7.2.2. Sectoral and firm level effects ....................................................................... 166
7.2.3. Determinants of the spillover effects ............................................................. 167
7.2.4. Other macroeconomic news spillover impacts .............................................. 168
APPENDICES ............................................................................................................. 169
REFERENCES ............................................................................................................ 177
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LIST OF TABLES
Page
Table 3.1- Descriptive statistics of the Feds and the ECBs target rate
announcements and news ........................................................................................... 36
Table 4.1 - Descriptive statistics of the RBAs and the Feds target rate news ......... 51
Table 4.2 - Wald test of the unbiasedness of expectations of monetary policy
announcements ........................................................................................................... 54
Table 4.3 - Descriptive statistics of the Australian financial market returns ............. 56
Table 4.4 -A priori expectations ................................................................................ 59
Table 4.5 - EGARCH(1,1) estimations of daily returns ............................................. 65
Table 4.6 - The RBAs news effects on the Australian financial markets ................. 70
Table 4.7 - The RBAs asymmetric surprises effects on the Australian financial
markets ....................................................................................................................... 72
Table 4.8 - Spillover effects of the Feds target rate news in the Australian financial
markets ....................................................................................................................... 79
Table 4.9 - Asymmetric spillover effects of the Feds target rate news in the
Australian financial markets ....................................................................................... 80
Table 4.10 - Nonews effects on the Australian financial markets .............................. 81
Table 5.1 - Descriptive statistics of the Asia Pacific stock markets returns ............. 92Table 5.2 - Granger causality tests for the Fed and the ECB ..................................... 98
Table 5.3 - Baseline model results ........................................................................... 101
Table 5.4 - The Feds target interest rate news spillover effects .............................. 106
Table 5.5 - The ECBs target interest rate news spillover effects ............................ 107
Table 5.6 - The US Feds and the ECBs Joint spillover effects .............................. 110
Table 5.7 - The Feds and the ECBs interest rate news effects estimated with
indirect effects via index return spillovers ............................................................... 112
Table 5.8 - The Feds and the ECBs interest rate news effects on domestic markets.................................................................................................................................. 114
Table 5.9 - Spillover effects of the USs and the euro areas stock markets on the
Asia Pacific markets ................................................................................................. 115
Table 5.10 - Marginal contribution of direct effect given indirect effect ................. 117
Table 5.11 - The policy cycle impacts ..................................................................... 122
Table 5.12 - The Fed and the ECB asymmetric effects ............................................ 125
Table 6.1 - Descriptive statistics of the Asia Pacific currency markets returns ...... 137
Table 6.2 - EGARCH(1,1) estimations of daily returns ........................................... 142Table 6.3 - The Feds and the ECBs target interest rate news spillover effects ..... 147
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Table 6.4 - Joint spillover effects of the US Feds and the ECBs target interest rate
news .......................................................................................................................... 153
Table 6.5 - Asymmetric news spillover effects ........................................................ 155
Table 6.6 - The Feds and the ECBs news effects on the USD/EUR pair .............. 158
APPENDICES
Appendix A - Macroeconomic announcements made on the same date as the RBA's
target rate announcements ........................................................................................ 170
Appendix B- Granger causality tests for the Fed and the RBA ............................. 171
Appendix C, Table C.1 - The US financial market returns and the US Feds target
interest rate news effects .......................................................................................... 174
Appendix D - Controlled macroeconomic announcements ..................................... 176
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LIST OF FIGURES
Page
Figure 5.1 - Testing horizons...................................................................................... 91
Figure 5.2 - Direct and indirect effects ..................................................................... 111
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LIST OF ABBREVIATIONS
ABS Australian Bureau of Statistics
ANZ Australia and New Zealand Banking Corporation
AUD Australian Dollar
CAB Current account balance
CAC French stock market index, Cotation Assiste en Continu
(Continuous Assisted Quotation)
CBA Commonwealth Bank of Australia
CBOT Chicago Board of Trade
CET Central European Time
CPI Consumer Price Index
DAX German stock market index (Deutscher Aktien Index)
DJIA Dow Jones Industrial Average Index
ECB European Central Bank
ESCB European System of Central Banks
EGARCH Exponential autoregressive conditional heteroscedasticity
EST Eastern standard time
EUR The Euro
Fed The United States Federal Reserve System
FOMC Federal Open Market Committee
GARCH Autoregressive conditional heteroscedasticity
GDP Gross Domestic Product
HICP Harmonised Index of Consumer Prices
HSI Hang Seng Index
IAPT International Asset Pricing Theory
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IDR Indonesian Rupiahs
JIC Jakarta Stock Exchange Composite Index
JPY Japanese Yen
KLCI Kuala Lumpur Stock Exchange Composite Index
KRW Korean Won
KRX100 Korea Exchange 100 Index
MPS MIT/Penn/Social Science Research Council (Modigliani
(1971)s model)
MRO Main refinancing operations
NAB National Australia Bank
NEER Nominal effective exchange rate
NKY Japanese NIKKEI 225 Index
NZD New Zealand Dollar
NZSE50FG New Zealand Exchange Limited 50 Free Float Total Return
Index
OMOs Open Market Operations
PCOMP Philippine Stock Exchange PSEi Index
PHP The Pilipino Peso (PHP)
RBA The Reserve Bank of Australia
RET Retail sales growth rate
RTT Retail trade
S&P/ASX 200 Standard & Poors/Australian Stock Exchange 200 Index
S&P500 Standard & Poor's 500 Index
SET Stock Exchange of Thai Index
SHCOMP Shanghai Stock Exchange Composite Index
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STI Singapores Straits Times Index
TD Trade deficit
TWD Taiwanese Dollar
TWSE Taiwan TWSE Index
UE Unemployment rate
USD The United States Dollar
WBC Westpac Banking Corporation
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LIST OF JOURNAL PUBLICATIONS FROM THE
DISSERTATION
1. A shorter version of Chapter 4 is published inResearch in International Businessand Finance 22 (3), pp. 378-395, 2008. It has also received the Best paper award
at the 2008 International Business and Economics Research Conference, Nevada,
USA.
2. A shorter version of Chapter 5 is published in Journal of International FinancialMarkets, Institutions & Money 19 (3), pp. 415-431, 2009.
3. A shorter version of Chapter 6 is published in International Research Journal ofFinance and Economics 20, pp. 27-45, 2008.
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CHAPTER 1 - INTRODUCTION
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"Policymakers often have to act, or choose not to act, even though we may not fully
understand the full range of possible outcomes, let alone each possible outcome's
likelihood."
Alan Greenspan, January 3, 2004
1.1. Objectives of the thesisSince the abandonment of monetary aggregate targeting in the mid-1980s,
central banks of advanced countries have moved to targeting policy interest rates and
public announcement of decisions on the interest rate target is a common practice in
most central banks. Any change in the target rate constitutes an adjustment in the
monetary policy stance, and the unexpected component of the change constitutes
news.
As the central banks target interest rate decisions impose interest rate risk to
most market participants, it is widely documented that in the days approaching a
central banks monetary policy meeting, market participants anticipate at least two
important factors. First, they will predict the direction of the target rate action, i.e.
whether the central bank will raise, cut or leave its target interest rate unchanged.
Second, they will also anticipate the magnitude of such policy action, i.e. by how
much the central bank will raise or cut its target rate? Accordingly, market
participants must take positions based upon their expectations of the impending
announcements of the central banks target interest rate stance. This expected part is,
thus, already factored into the market prices observed immediately prior to the
announcement. If the actual target rate announced is different from that already
priced, markets react to this surprise (or news) component accordingly. Therefore,
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central banks influence financial markets through the control over the target interest
rates and the markets expectation on the future courses of the respective target rates.
Furthermore, global financial markets have become increasingly integrated
over the past decades. During this integration process, monetary policies play a key
role in driving financial market linkages across national markets. Given the fast pace
of real and financial integration, it is widely recognised that target interest rate
decisions made by a central bank, especially policy decisions from the Fed, are
keenly monitored by not only the domestic market participants but also by foreign
market participants. However, the nature and the transmission channels through
which target interest rate news dissipates are still not well understood. In addition,
while the impact of the Feds monetary policy on domestic markets is well
documented for the US markets, the spillover impact of the Feds target rate news to
foreign markets is much less obvious.
This thesis empirically investigates the direct impacts of the target interest
rate news on the domestic financial markets, and the spillover effects from one
central bank to foreign financial markets. Specifically, this thesis presents three
empirical investigations that address the following important questions:
1. What are the nature, direction and magnitude of the impacts of theRBAs target interest rate surprises on the Australian financial
markets?
2. What are the nature, direction and magnitude of the spillover effectsof the Feds and the ECBs target rate news on the Asia Pacific
financial markets?
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3. The Feds and the ECBs target rate news would have both direct andindirect influences on foreign markets. Moreover, there is ample
evidence that the Asia Pacific markets are influenced by the USs and
the euro areas markets (the indirect effects). Therefore, given the
presence of such indirect effects, whether the Feds and the ECBs
target rate news has any incremental explanatory power?; and
4. How quickly is the target interest rate news from the Fed and the ECBabsorbed in the Asia Pacific markets?
1.2. Contributions to the literatureThis thesis is conceptually linked to two strands of the literature on the
monetary policy news. First, it contributes to the literature on the impacts ofdomestic
target rate news by empirically investigating the impacts of the RBAs target rate
news on the Australian financial markets via different channels ranging from interest
rates, stock markets, exchange rates, and credit channels (via bank lending
mechanism). Australian financial markets have been chosen as a case study in
Chapter 4 due to its growing importance and integration with other markets in the
Asia Pacific region and with the US. Furthermore, Australian financial markets are
regarded as efficient markets as Edey and Elliott (1988) found, thus market responses
to interest rate news could have been detected relatively quickly. Therefore, an
empirical test on the spillover impacts of the Feds target interest rate news on the
entire financial markets of a single country seems to be crucial before going further
to the extensive and detailed investigations for such effects on the stock markets and
the exchange markets of a large number of countries in the Asia-Pacific region in
Chapters 5 and 6. However, the current literature on the RBAs cash rate effect is
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limited to the investigation of the announcement impact on the first moment of
Australian market returns, see for example Gasbarro and Monroe (2004), and Diggle
and Brooks (2007). Therefore, a thorough investigation focusing on the impact of the
unexpected component (or news) of the RBAs target rate announcements would
provide direct and comprehensive evidence on the impacts of the RBAs target rate
news on the Australian financial markets.
Second, this thesis attempts to investigate the nature of the international
spillover effects of a central banks target rate news on foreign markets. While the
spillover impacts of the Feds news on some national markets have been
documented, 4 the literature is missing a thorough investigation of the spillover
effects of the Feds news on the Asia Pacific markets.This is a significant oversight
as the information leadership role of the US in the Asia Pacific region is well
documented, see inter alia Arshanapalli et al. (1995), Liu et al. (1998), Liu and Pan
(1997), Ghosh et al. (1999), Ng (2000), Miyakoshi (2003), Kim (2003, 2005),
Phylaktis and Ravazzolo (2005).5 In addition, while there are some studies focusing
4See for example, Bredin et al. (2005) examine the Feds news effects on the Irish stock market
volatility; Ehrmann and Fratzscher (2003, 2005a) investigate the Feds news effects on the euro area
money market returns, while Hausman and Wongswan (2006) examine such spillover effect on the
stock, debt and foreign exchange markets. The Feds interest rate news has shown to be transmitted to
these markets and the spillover effects are strongly felt. However, the transmission in the opposite
direction is found to be weak, see Ehrmann and Fratzscher (2005a).
5For Australia in particular, Kim and Sheen (2000) show that the Australian interest rates (90-day and
10-year rates) react strongly to the first and second moments of the corresponding US rate
movements. Masih and Winduss (2006) report a straightforward cointegration relationship between
the Australian and the US interest rates, whereas Narayan and Smyth (2004) show similar evidence
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on the first moment spillover effects of the Feds target interest rate news on foreign
markets, very limited evidence has been shown for the volatility spillover effects of
the Feds news. This significant gap needs to be addressed because the target rate
news does not only affect the direction of market movements in foreign markets (first
moment influence) but also influences the trading environment, and hence the level
of volatility (second moment effect). For example, Faff et al. (2009) shows that
conditional stock market return volatilities have contemporaneous and positive
systematic exposures to global return volatilities. Furthermore, Kearney (2000)
shows that the global equity markets volatility is caused mostly by volatility in the
US markets. Therefore, to the extent that the US stock market responds significantly
to the Feds news, and that the foreign markets look to the U.S markets for trading
momentum, there is potential for the Feds news to be significantly priced in foreign
markets, especially in the Asia Pacific region where both financial and real
integration with the US is growing rapidly.
Another oversight in the literature is the relative lack of investigation of the
spillover effects of the ECBs news.6 Given the increasing prominence of the euro
areas equity markets, and the increasing real and financial integration between the
Asia Pacific region with the euro area,7 there is strong potential that the ECBs news
for the stock markets. Moreover, Kim (2005) reports a direct causal information flow from the US
stock market to that of Australia.
6Although there are some recent studies on the impacts of the ECBs news on European stock
markets, see e.g. Bohl et al. (2008), and Bredin et al. (2009).
7The EU is the largest trading partner for Australia and China; second largest trading partner for
Hong Kong, New Zealand, Taiwan, and Thailand; the third for Indonesia, Japan, Malaysia, and
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would have spillover impacts on the financial markets in the latter. Finally and
importantly, the literature is silent on how quickly the news from a central bank is
absorbed in foreign markets.
Against this background, this thesis contributes to the current literature in
several ways. First, it provides comprehensive evidence for the impacts of the RBAs
target rate news on both the mean and volatility of the Australian interest rate
changes, the Australian dollar and stock market returns. In so doing, this thesis
contributes to the current literature on the impacts ofdomestic target rate news.
Second, this thesis fills significant gaps in the literature by providing
comprehensive evidence on the spillover effects of the Feds and the ECBs target
rate news on both the mean and volatility of the Asia Pacific stock and currency
market returns. Furthermore, the thesis not only documents the presence of the news
effects but also highlights the incremental explanatory power of the target interest
rate news in the presence of the indirect effects from the USs and euro areas stock
markets.
Third, in order to shed light on the adjustment speed of the Asia Pacific
markets to the Feds and the ECBs news, this thesis investigates the relative speed
of news absorption by breaking down the daily horizon into the overnight and the
intraday horizon. Thus, this thesis examines the extent of persistence effects, if any,
of the Feds and the ECBs news effects on the Asia-Pacific markets.
Singapore; and the fourth for Korea and the Philippines (see http://ec.europa.eu/trade/issues/bilateral/
data.htm).
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This thesis presents three independent empirical inquiries on the impacts of
central banks target interest rate news on both domestic and foreign markets. In
particular, Chapter 48
provides comprehensive empirical evidence for the impacts of
the RBAs target rate news on various segments of the Australian financial markets,
namely debt, stock and foreign exchange markets. We show that the RBAs news
had a significant impact on the first moment of market returns/changes in line with a
priori expectations, and the conditional volatility in most of the markets was
significantly higher following the news. Asymmetric news effect is also observed for
the Australian interest rate changes where markets tended to respond more strongly
to unexpected rate rises than rate cuts. Furthermore, while the US Feds news
influences only the USD/AUD exchange rate, the Australian market volatility was
significantly lower in all market segments following the Feds news. These findings
are informative not only to the RBAs decision makers to improve its conduct of
monetary policy but also to market participants in designing trading mechanisms as
well as risk management strategies in response to both domestic and external interest
rate shocks.
Chapter 59 examines the spillover effects of the US Feds and the ECBs
target interest rate news on the market returns and return volatilities of twelve stock
markets in the Asia Pacific region over the period 1999-2006. In addition to close-to-
8A shorter version of this chapter is published in Research in International Business and Finance,
22(3), pp. 378-395, 2008.
9A shorter version of this chapter is published in Journal of International Financial Markets,
Institutions & Money 19 (3), pp. 415-431, 2009.
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close return over market close on calendar day t-1 to the close on calendar day t
(close-to-close), it is split into the overnight horizon over the close of day t-1 to the
open on day t(close-to-open), and the intraday horizon over the open on day tto the
close on day t (open-to-close). This enables us to capture the Asia Pacific stock
markets first reaction to the news (overnight returns) and delayed reactions, if any,
during the trading day in the Asia Pacific region (intraday returns). The news
spillover effects on the returns are generally consistent with the literature where a
majority of stock markets shows significant negative returns in response to
unexpected rate rises. Whilst the results of the speed of adjustment for the Feds
news are mixed across the markets, the ECB news was absorbed more slowly, in
general. The return volatilities of the Asia Pacific stock markets were higher in
response to the interest rate news from both sources. In addition, both the Fed and the
ECB news elicited delayed or persisting volatility responses. These findings have
important implications for the Asia Pacifics policy makers and market participants
alike in anticipating and managing potential spillover effects from the Feds and the
ECBs so as to have forward looking policy responses and hedging strategies.
Chapter 610 examines the spillover impacts of the US Feds and the ECBs
target interest rate news on the first two moments of seven Asia Pacific exchange
rates against the US dollar and the euro over the period 1999-2006. The spillover
effects on the mean are generally consistent with the literature where a majority of
currencies depreciates against the USD and the EUR in response to unexpected rate
10A shorter version of this chapter is published in International Research Journal of Finance and
Economics, 20, pp. 27-45, 2008.
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rises. Both the Fed and the ECB news elicited delayed or persisting volatility
responses. The ECBs news tends to confirm the Feds decision. This relationship
tends to help reduce volatility in the Asia Pacific currency markets. This finding
provides useful information for the Asia Pacific monetary authorities, especially
those who are targeting exchange rates, in designing and implementing their own
monetary policies. These are also useful to currency traders in designing forward
looking trading strategies. Furthermore, these findings also shed lights on the lead-
lag relationship between the Feds and the ECBs decision markings. The belief that
the ECB follows the Fed in setting its policy is so strong among market participants
such that empirical evidence seems to be crucial. Despite the fact that the ECBs
news arrives after the Feds news, this chapter provides evidence that the ECBs
news has its own merit in the Asia Pacific currency markets and helps to resolve
differences in belief among market participants.
In short, this thesis is the first study that provides comprehensive evidence on
the influence of the RBAs target interest rate news on the Australian financial
markets, and the spillover effects of the target interest rate news from the Fed and the
ECB on both the first two moments of the Asia Pacifics equity and currency
markets returns.
1.3. Thesis outlineThis thesis consists of seven chapters. Chapter 2 provides a literature review
of the target interest rate news effects. Chapter 3 discusses the methods of isolating
the unexpected component of the target interest rate announcements, and then
proceeds to discuss the key methodologies used for empirical investigations
contained in the following three chapters. Chapter 4 empirically investigates the
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domestic effects of the RBA as well as the spillover effects of the Fed on the first
two moments of the Australian debt, stock and currency markets. Chapters 5 and 6
focus on the spillover influences of the target interest rate news from the Fed and the
ECB on the first two moments of the Asia Pacific stock and currency market returns,
respectively. Chapter 7 concludes the thesis and offers directions for future research
in the area of target interest rate news effects.
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CHAPTER 2 - LITERATURE REVIEW OF TARGET
RATE NEWS EFFECTS
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2.1. The impacts of the central bank target interest rate on domestic financialmarkets
This section discusses the underlying theory and empirical evidence for the
influences of the central bank target interest rate on various domestic financial
markets including the debt, equity and currency markets, which are the focuses of
this thesis investigations.
2.1.1. The debt marketsAs Mishkin (1996) pointed out, to stimulate the economy the central bank
increases the money supply, lowering a short-term nominal target interest rate, e.g.
the Fed funds rate, resulting in lower short-term real interest rates assuming that the
central bank has the capability to conduct Open Market Operations (OMOs) in ways
such that it can vary the money supply to move the target interest rate in the desired
direction. The expectation hypothesis of the term structure suggests that lower
(higher) short-term real interest rates could result in lower or higher long-term real
interest rates depending on market expectations on the future paths of nominal rate
and inflation. The changes in long-term interest rates then stimulate (depress)
consumer and investor spending raising (lowering) Gross Domestic Product (GDP)
ultimately.
The effect of announcements of monetary policy changes on the entire yield
curve has been exhaustively investigated. Taylor (1995) shows that there is strong
empirical evidence for substantial interest rate effects on consumer and investment
spending through the interest rate channel. The earliest study in monetary
announcement effects is Cook and Hahn (1989), who first documented the
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connection between the Fed funds rate and market rates and showed that over the
1974-1979 period changes in the Fed funds rate had a significant positive impact on
the yields of US Treasury securities at all maturities. However, their results might
partly be due to a period of less systematic and transparent target interest rate
decision making.
The effect of a monetary policy decision on long-term rates might be
different from that on shorter-term rates. Changes at the long end of the yield curve
can at least in part be attributed to the markets views on the central banks
credibility or its capability to control inflation. Therefore, a tightening of monetary
policy can be compatible with a reduction in long-term interest rates if markets
perceive the tightening as a credible step by monetary authorities to reduce inflation
in the long-run (see e.g. Thornton, 1998). On the other hand, other studies argue that
the effects of news surprises at the short and medium maturities mainly reveal
information about market participants beliefs of the central banks reaction function
(see e.g. Haldane and Read, 2000).
In recent decades, as the market anticipation of monetary policy has
improved, some of the potential impact of a target rate change would have already
been incorporated into asset prices by the time the decision was made, causing the
response to the actual announcement event to diminish (see Roley and Sellon, 1995).
However, from technical perspectives, this might also be because of the failure to
distinguish between the expected and unexpected components of the news. In his
seminal work, Kuttner (2001) showed that Treasury yields did not respond to
changes in the Fed funds rate that were already anticipated, while there was a large
and significant impact of the unanticipated component of the interest rate
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announcement. Demiralp and Jorda (2004) find that long-term rates react much more
in unison during announcement days than at any other times. Recently, Valente
(2008) shows that the Feds target rate news not only significantly affect the term
structure of interest rates in the US but also spillover to Hong Kong and Singapore
interest rates.
On the volatility side, Lee (2006) empirically investigates the one-day
response of interest rate volatility to Fed funds target rate changes over the period
1989-2003 and find a positive relation between the Feds news and the volatility at
all maturities. The volatility response to an unanticipated Fed policy action is
relatively large and highly significant for short-term interest rates. However, interest
rates at long maturities are found to be responsive to target rate changes, even if they
are anticipated when estimations take into account of structural change in association
with the Fed's policy disclosure beginning in 1994.
Notwithstanding there is strong empirical evidence for the Feds news
impacts on interest rates at all maturities, Bernanke and Gertler (1995) pointed out
that the macroeconomic response to policy-induced interest rate changes is
considerably larger than that implied by conventional estimates of the interest
elasticity of consumption and investment. This suggests that mechanisms other than
the interest rates, e.g. asset prices including the stock prices and exchange rates, may
also be at work in the transmission of monetary policy to the economy.
2.1.2. Stock marketsIn principle, monetary policy decisions can be transmitted to the economy via
two channels of equity price movements: investment and wealth effects. Tobin's
Theory of Investment provides a mechanism by means of monetary policy affecting
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the economy through its influences on the valuation of equities (see Tobin, 1969).
Tobin defines q as the market value of firms relative to the replacement cost of
capital. If q is high, firms will invest more because adding capital is cheap as the
market price of firms is high relative to the replacement cost of capital. As a result,
investment spending will rise. On the other hand, when q is low, firms will not
purchase new investment goods because the market value of firms is low relative to
the cost of capital.
How does monetary policy stance affect q? Expansionary monetary policy
action can lead to a higherq in at least two ways. First, as lower interest rates leaving
investors with less attractive alternatives or they have more money to spend. An
attractive place to spend is in the stock market, thus, increasing demand for equities
and consequently raising equity prices. Furthermore, lower interest rates making
fixed income securities, e.g. bonds, less attractive relative to equities, thereby
causing the price of equities to rise. In short, an expansionary policy stance will lead
to higher equity prices, then a higherq, and thus higher investment spending.
This channel has been empirically tested in various studies with mixed
evidence. For example Blanchard et al. (1993) argue that as a result of fads, bubbles,
or the influence of uninformed traders, stock prices may deviate from fundamentals.
In such situations, managers may find it in their interests to ignore the signals arising
from asset markets and invest on their own superior information. They find that
given proxies for fundamentals market value appears to play a limited role in
determining investment. Bond and Cummins (2000) make a similar argument and
find that investment responds much more strongly to a measure of q constructed
from profit forecasts than q constructed using the stock market. Gilchrist and Leahy
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on volatility than negative surprises, which is consistent with both the leverage and
volatility feedback hypotheses advocated by Black (1976) and French et al. (1987).
2.1.3. Exchange ratesThe monetary policy effects run from interest rates to exchange rates via the
uncovered interest rate parity condition relating interest rate differentials to expected
exchange rate movements. Thus, a cut in the target interest rate relative to foreign
interest rates would lead to a weaker currency due to now relatively lower real
domestic interest rate and would stimulate net exports and the overall level of
aggregate demand.
There is strong evidence for the impacts of monetary policy on exchange
rates, such as Faust and Rogers (2003) and Faust et al. (2003) find delayed
overshooting effects of the Feds news on the British Pound and German
Mark/Euro, and such policy shocks can explain only a small portion of currency
variability. Andersen et al. (2003) and Ehrmann and Fratzscher (2005b) show that
the USs and the euro areas (and Germans news before 1999) macroeconomic news
have a significant impact on the US dollar-euro exchange rate. Fatum and Scholnick
(2008) find that the news component of a tightening (loosening) of US monetary
policy is associated with a same day appreciation (depreciation) of the US dollar
against the British Pound, German Mark, and Japanese Yen. Furthermore, Lobo et al.
(2006) report that changes in the Feds interest rate target are positively related to
changes in the value of the dollar, and also provide evidence for the asymmetric
impact of the Feds news where unexpected rate rises have a larger effect than
unexpected rate cuts for the Pound, Mark, and Canadian dollar, whereas the opposite
is true for the Japanese Yen.
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2.1.4. The credit channelAsset values also play an important role in the credit channel advocated by
Bernanke and Gertler (1995). Advocates for the credit channel suggest that monetary
policy affects not only the general level of interest rates but also the size of the
external finance premium. Bernanke and Gertler (1995) suggested two mechanisms
explaining the link between monetary policy actions and the external finance
premium: the balance sheet channel and the bank-lending channel.
In the balance sheet channel, asset prices are especially important in that they
determine the value of the collateral that firms and consumers may present when
obtaining a loan. In frictionless credit markets, a fall in the value of borrowers
collateral will not affect investment decisions. However, in the presence of
information or agency costs, declining collateral values will increase the premium
borrowers must pay for external finance, which in turn will reduce consumption and
investment. Thus, the impact of policy-induced changes in interest rates may be
magnified through this financial accelerator effect.
The bank-lending channel relies on credit market frictions where banks play a
central role as they are especially well suited to solve asymmetric information
problem in credit markets. The essential insight is that because banks rely on
reservable demand deposits as an important source of funds, contractionary monetary
policy, by reducing the aggregate volume of bank reserves, will reduce the
availability of bank loans. In turn, as most firms and households rely heavily or
exclusively on bank financing, a reduction in loan supply will ultimately depress
aggregate spending.
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The empirical evidence on the credit channel is somewhat mixed. For
example, Miron et al. (1994) and Driscoll (2004) find little support for the bank-
lending channel of monetary transmission. However, Kashyap et al. (1993), Kashyap
and Stein (2000), Bernanke (1996), and Peersman and Smets (2005) provide
supporting evidence for the bank-lending channel. The two studies that examine the
monetary transmission by looking at the response of disaggregated stock returns to
monetary shocks show opposite results. Warner and Georges (2001) find no evidence
supporting a credit channel. In contrast, consistent with the credit channel, Ehrmann
and Fratzscher (2004) document firm-level heterogeneity in the effect of monetary
news on stocks based on financial constraints.
2.2. The spillover effects of foreign target interest rate newsAs the global financial market is increasingly integrated, it is necessary to
understand the driving forces behind such integration. Among this, international
transmissions or spillover effects of monetary policy actions of a central bank to
foreign markets have attracted attention. Target rate news from major economies
might affect other national markets via at least three channels.11 Firstly, foreign
target rate news would directly affect domestic markets if domestic monetary
authorities were targeting exchange rates. An unexpected monetary policy stance in
the US, for example, would results in a corresponding action from other countries,
e.g. Singapore or Hong Kong, to maintain the exchange rate targets. Secondly, due to
increasing global financial integration, monetary policy news from the US, for
instance, might affect the markets in other countries via capital flows and other
11 See, for example Ehrman and Fratzscher (2003).
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arbitrage activities. The final channel is through real integration such that foreign
announcements might reveal important information about macroeconomic conditions
of other countries. For example, if foreign monetary policy decisions change
domestic macroeconomic conditions through effects on the terms of trade with the
trading partners, such decisions may provide news not only about foreign economic
conditions but also about the prospects of the domestic economy.12
The literature documents some evidence for the spillover impacts of the Feds
funds rate news on foreign markets. For example, Ehrmann and Fratzscher (2003,
2005a) show that interest rates in the US, Germany and euro area react strongly to
respective domestic target rate news. Furthermore, the response to foreign target rate
news differs across markets where both German and euro area markets respond
strongly to the Feds news, the opposite direction effect is weaker.
Another strand of the target rate spillover effect literature is to identify the
determinants of the spillover effects across markets. Ehrmann and Fratzscher (2006)
focus on the link between the US monetary policy and 50 foreign stock markets and
show that the US monetary policy news has significant and sizable effects on foreign
stock prices. Moreover, they provide evidence that a countrys real and financial
linkages with the world, and not the bilateral integration with the US, are key
determinants of cross-country variation in response. In particular, they show that the
sensitivity to US monetary policy news is higher in those countries that are more
integrated globally rather than bilaterally with the US in real and financial terms.
This suggests that domestic financial conditions in any country do not necessarily
12 See Ehrmann and Fratzscher (2005a) for further details.
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depend on the financial conditions in the US market, but on some other effects that
are due to the complex mechanisms of the global financial and real linkages. On
currency markets, Fratzscher (2008) analyses the link between economic
fundamentals, including the Feds news, and exchange rates from a cross sectional
perspective. He shows that the USs shocks, including the Feds news, exerted
heterogeneous impacts across 26 main currencies in the basket of the US dollar
trade-weighted nominal effective exchange rate (NEER). More importantly, he
shows that not only exchange rate regimes but also the degrees of financial
integration are key determinant of such heterogeneity in responses.
In a more comprehensive study, Hausman and Wongswan (2006) investigate
the Feds news impact on the stock, debt and foreign exchange markets of 49
countries including both developed and emerging markets. They also take a step
further to explore the transmission channels of the US monetary policy to foreign
economies via real economic linkages, financial linkages, and exchange rate regimes.
They find that foreign asset prices respond to the Feds news and cross-country
responses are related to a countrys exchange rate regime. Equities and interest rates
respond more strongly to the Feds news in countries with less flexible exchange rate
regime, while exchange rates respond less. Financial integration, proxied by equity
market capitalization owned by the US investors, and trade linkages with the US are
also strongly related to cross country responses.
In summary, this thesis is well related to two strands of the literature on the
monetary policy news impacts as highlighted above. First, it provides comprehensive
evidence on the target interest rate news on the key segments of the Australian
financial markets, namely debt, stock and foreign exchange markets. Second, this
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thesis documents and discusses evidence for the international spillover effects of the
Feds and the ECBs target interest rate news on both the conditional mean and
volatility of the Asia Pacific stock and exchange rate returns.
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This chapter begins with discussions on the institutional arrangements of key
policy interest rates targeted by three central banks considered in the later chapters.
Then, Section 3.2 shows how the unexpected component of the target rates is
generated and Section 3.3 discusses modeling issues.
3.1. Central banks target interest rate communicationsThe last two decades have witnessed a surge in central banks efforts to
improve policy transparency via various forms of policy communications to the
public. This is because there is a strong notion that a prerequisite for an independent
central bank is its accountability to the public. Therefore, central banks have
responsibilities to timely inform policy actions to the public and explain to the extent
possible the underlying rationales for such policy actions. Although central banks
with similar objectives follow different methods of communication to the public, a
common theme is that central banks would communicate their decisions on the target
interest rate to the public. The timing and details of this communication however
differ across central banks (see Blinderet al., 2008). The following sections briefly
provide backgrounds of the three central banks target rates: the RBAs cash rate, the
Fed funds rate and the ECBs main refinancing rate.
3.1.1. The RBAs cash rate targetThe Reserve Bank Act 1959, Section 10(2) states that It is the duty of the
Reserve Bank Board, within the limits of its powers, to ensure that the monetary and
banking policy of the Bank is directed to the greatest advantage of the people of
Australia and that the powers of the Bank ... are exercised in such a manner as, in the
opinion of the Reserve Bank Board, will best contribute to:
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(a) the stability of the currency of Australia;
(b) the maintenance of full employment in Australia; and
(c) the economic prosperity and welfare of the people of Australia.
In practice, the RBAs monetary policy's principal medium-term objective is
to control inflation. In line with previous understandings between the Federal
Government and the RBA in the Statement on the Conduct of Monetary Policy
issued in 2007, the Governor and the Treasurer agreed that the appropriate target for
monetary policy is to achieve an inflation rate of 2-3 per cent on average. Therefore,
the inflation target is the core of the Australian monetary policy framework. It
provides discipline for monetary policy decision-making, and serves as an anchor for
private sector inflation expectations.
The RBAs Board usually meets eleven times each year on the first Tuesday
of the month except in January to decide on its monetary policy stance. Therefore,
market participants know the meeting dates in advance. Through OMOs, by
managing the supply of funds available to banks in the official money market, the
RBAs Domestic Markets Department maintains conditions in the official money
market to keep the cash rate, which is the rate charged on overnight loans between
financial intermediaries, at or near an operating target decided by the Board.
From January 1990, the RBA started to publicly announce its monetary
policy decisions. From January 1998 until November 2007, the RBA Board's
decision to change or leave the cash rate unchanged is announced in a media release
at 9:30 am Australian EST (GMT+10) one day following the board meeting.Since
December 2007, a media release is issued at 2.30 pm after each Board meeting.
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3.1.2. The U.S. Federal Reserves federal funds target rateFederal Reserve Act, Section 2A states that the Board of Governors of the
Federal Reserve System and the FOMC shall maintain long-run growth of the
monetary and credit aggregates commensurate with the countrys long-run potential
to increase production, to promote effectively the goals of maximum employment,
stable prices and moderate long-term interest rates. However, it has been argued
that despite its multiple objectives, the Fed has traditionally placed more emphasis on
achieving price stability and, in recent years, there have been calls for a clearer price
stability mandate for the Fed (see e.g. Wynne, 1999 and Bernanke, 2003).
The major tool the Fed uses to influence the supply of reserves in the banking
system is OMOs conducted at the Federal Reserve Bank of New York. The short-
term objective for OMOs is specified by the FOMC. This objective can be a desired
quantity of reserves or a desired price (the Fed funds rate). 13 Although the Feds
objective for OMOs has varied over the years, during the 1980s, the focus gradually
shifted toward attaining a specified level of the Fed funds rate. Since 1994, the
FOMC has been announcing the Fed funds target rate after its regularly scheduled
(eight meetings a year) and ad hoc meetings at 2:00 pm US Eastern Standard Time
(EST, GMT-5), unless otherwise specified. After each meeting, the Fed provides a
short press release containing the decision, a concise explanation of its underlying
reasoning and sometime some forward-looking hints.
13The Fed funds rate is the interest rate at which depository institutions lend balances at the Fed to
other depository institutions overnight.
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Following is a typical example of the FOMCs press release after its meeting
on January 31, 2007.
The Federal Open Market Committee decided today to keep its target for
the federal funds rate at 5-1/4 percent.
Recent indicators have suggested somewhat firmer economic growth, and
some tentative signs of stabilization have appeared in the housing market. Overall,
the economy seems likely to expand at a moderate pace over coming quarters.
Readings on core inflation have improved modestly in recent months, and
inflation pressures seem likely to moderate over time. However, the high level of
resource utilization has the potential to sustain inflation pressures.
The Committee judges that some inflation risks remain. The extent and timing
of any additional firming that may be needed to address these risks will depend on
the evolution of the outlook for both inflation and economic growth, as implied by
incoming information.
As can be seen, the first paragraph clearly and concisely announces the
FOMCs target rate decision, i.e. to leave the Fed funds target rate unchanged. The
next two paragraphs state the underlying rationales for the decision and the last
paragraph offers some hints on the likelihood of the FOMCs decisions in the future
meetings.
3.1.3. The European Central Banks main refinancing rate targetArticle 105 (1) of the Maastricht Treaty states that the primary objective of
the European System of Central Banks (ESCB) shall be to maintain price stability
and that without prejudice to the objective of price stability, the ESCB shall support
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the general economic policies of the Community with a view to contributing to the
achievement of the objectives of the Community as laid down in Article 2. In this
respect, Article 2 states that the objectives of the Community are, inter alia, to ensure
a high level of employment (), sustainable and non-inflationary growth, and a
high degree of competitiveness and convergence of economic performance.
As the ECB was established as the core of the Eurosystem and the ESCB, the
Treaty thus establishes a clear hierarchy of objectives for the ECB and assigns
overriding importance to price stability. Moreover, the ECB has made public its
precise quantitative definition of price stability. The ECB has defined price stability
as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for
the euro area of below 2%. In the pursuit of price stability, the ECB aims at
maintaining inflation rates below, but close to, 2% over the medium term.
For the ECB, the interest rate on the main refinancing operations (MRO),
regular liquidity-providing reverse transactions with a frequency and maturity of one
week, is perceived to be the target policy interest rate as it plays a pivotal role in
pursuing the ECBs OMOs.14 Although the Governing Council meets twice a month,
it normally makes a monetary policy decision at the first of the two meetings, after
14The other key interest rates for the euro area are: (i) the rate on the deposit facility which banks can
use to make overnight deposits with the national central banks and normally provides a floor for the
overnight market interest rate; and (ii) the rate on the marginal lending facility, which banks can use to
obtain overnight liquidity from the national central banks against eligible assets, and this rate normally
provides a ceiling on the overnight market interest rate. These two rates are for standing facilities,
which aim to provide and absorb overnight liquidity, signal the general monetary policy stance and
bound overnight market interest rates.
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which a press release announcing the decision on the key ECB interest rates is made
at 1:45 pm Central European Time (CET, GMT+1). Thus, the ECBs Governing
Council has aligned its policy interest rate decision frequency closely with that of the
Fed.15 However, unlike the other two central banks, the ECB does not only release a
press statement with the policy decision but also holds a press conference on the
Governing Councils meeting day, including a question and answer (Q&A) session at
2:30 pm CET. This thesis empirically investigates the impact of news arising from
the ECBs press releases at 1:45 pm CET only.
3.2. Target interest rate newsEmpirical work that fails to decompose monetary policy changes into
expected and unexpected components is also likely to lead to biased results due to
errors in variables. In particular, a number of theories based on the assumption of
efficient markets would suggest that only unanticipated changes in policy should
influence asset prices immediately (i.e. on the announcement day of a monetary
policy change asset prices should respond only to the surprise element of such a
change). On the other hand, anticipated changes in policy should not affect asset
prices but instead such information should have already been factored into the asset
prices observed immediately prior to the announcement. Otherwise, arbitrage
opportunities would exist and markets would be deemed inefficient. Studies that
examine the influence of policy rate changes and fail to decompose actual changes
15This is the case since November 8, 2001 as announced by the President of the ECB. However, the
Governing Council can still decide to change the key ECB interest rates at any time regardless of
previously scheduled meetings if needed.
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into these two components are liable to lead to biased results. For example, Cook and
Hahn (1989) fail to take account of expected and unexpected changes in monetary
policy and so their results are not credible. Other studies that suffer from this
problem include Concoveret al. (1999) and Durham (2001).
Recent research has attempted to distinguish between unexpected and
expected changes in target interest rate announcements. The news component is
estimated by (i) the difference between the actual announcement and the
median/mean of market surveys; (ii) derivation of unexpected component from
future markets data; or (iii) derivation of expectations based on forecasts from
regression analysis then subtract these expectations from the actual announcements
for unexpected component. However, as liquidity and range of instruments offered in
the futures markets have been improving, one can directly derive a measure of the
surprise element on a continual basis using data on futures contracts. Therefore, the
second approach has become popular and is also used in this thesis.
3.2.1. The RBAs cash rate newsThe best proxy for Australian market expectation on the RBAs upcoming
target rate announcement is the 30-Day Interbank Cash Rate Futures contract.
However, the launch date for this contract was August 12, 2003, thus it is not
practical for this investigation. We instead use the market surveys of target interest
rates from January 1998 to December 2006. Days surrounding the RBAs target rate
announcements, the financial press reports what the market consensus was at the
time of each announcement. These reports were searched on the Factiva database
over a few days before and after the RBAs scheduled announcements. The
unbiasedness and efficiency of the expectation data generated this way has been
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tested and the results suggest that the market-based expectations are unbiased
predictors of the RBAs interest rate announcements where the null hypothesis
cannot be rejected even at 90% level of confidence. The news component of each
announcement is then the difference between the actual target rate change
announcement and the market expectation. Chapter 4 discusses this methodology of
news extraction in details.
3.2.2. The Feds and the ECBs target rate newsFor the Fed, some of the earlier studies employed market survey expectations
to proxy for expected target rate announcements (e.g. Reinhart and Simin, 1997).
However, recent studies have instead relied on market price-based proxies thanks to
the developments of the financial markets. Krueger and Kuttner (1996) find that the
Fed funds futures rate is an efficient predictor of the Fed funds target rate, and
therefore an appropriate market-based measure of policy expectations. Grkaynaket
al. (2007) later confirm this finding. In his seminal work, Kuttner (2001) uses the
Fed funds futures rates to separate the target rate changes into anticipated and
unanticipated components. He finds that the US Treasury bill, note and bond yields
responses to anticipated changes in the target rate are small, while the responses to
unanticipated changes are large and significant. Bomfim (2003) extends Kuttner
(2001) to asset return volatilities and finds that asset returns are more volatile
following announcements containing unexpected rate changes.
On the other hand, the early literature on the ECBs news employed price-
based proxies to gauge the market expectations on the ECBs target rate
announcements. However, the choice of market instruments differs across
researchers. Gasparet al. (2001) use EONIA (Euro OverNight Index Average, the
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effective overnight reference rate for the Euro) to gauge the probability attached to a
change in the ECBs target interest rate before the Governing Councils meeting.
Perez-Quiros and Sicilia (2002) propose a principal components approach that
utilizes the daily changes of different money market interest rates including the
EONIA, the one-week, one-, two- and three-month EONIA swap rates and the
closest three-month EURIBOR futures rates. Their approach is to extract the key
common component that shapes the evolution in all the above rates. Wrtz (2003)
measures the interest rate change expectations from the forward rate implied by the
one- and two-month EONIA swap rates. However, due to the high volatility and the
impacts of liquidity considerations rather than the monetary policy considerations as
identified by Bindseil (2002) in underbidding scenarios, it seems that the EONIA is
not the best proxy for the market expectation on the ECBs upcoming interest rate
announcements. Bernoth and Von Hagen (2004) find that the three-month EURIBOR
futures rate is an unbiased predictor of the euro area policy rate changes. Thus, the
literature seems to suggest that a market-based approach using futures rates would
provide us with the markets unbiased expectations on the ECBs upcoming interest
rate announcements. Ehrmann and Fratzscher (2003, 2005a) utilize the Reuterss
survey of 25-30 market participants conducted on the Friday before each meeting of
the ECBs Governing Council as a proxy for the market expectations on the
upcoming interest rate decision. However, these surveys fail to capture any change in
market expectations that occur between Friday and the actual announcement date.
Against this background, this thesis uses Kuttner (2001)s methodology to
generate the unexpected components of the Feds and the ECBs target rate
announcements from January 1999 to December 2006. Current-month Fed funds
futures contracts traded on the Chicago Board of Trade (CBOT) are used to extract
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the Feds news, and the three-month EURIBOR futures contracts traded on the
EUREX for the ECBs surprises.16
The news component of the Feds target rate announcement on day d of
month m can be derived from the implied change in the price of the futures contract.
Since the Fed funds futures settlement price is based on the monthly average of the
spot Fed funds rate, it is necessary to account for the number of days affected by the
announcement in that particular month as in equation (3.1). The 3-month EURIBOR
futures settlement price is based on the reference interest rate (EURIBOR) for three-
month euro term-deposits on the last trading day, and so the news component of the
ECBs target interest rate announcement is calculated as in equation (2.1) without the
scaling factorD/(D-d).
( )0 1,0,
= dmdmu ff
dD
Di
(3.1)
where: ui is the unexpected target rate change;
f0m, dis the current month Fed funds futures rate for the Fed and three-
month EURIBOR futures rate for the ECB;
f0m, d-1 is the futures rate on the day prior to the announcement;
D is the number of days in the month; and
D-dis the number of days in the month affected by the announcement.
16Although 1-month EONIA and EURIBOR Futures contracts are better proxies, the former was
introduced only on January 27, 2003, and the latter was delisted on March 16, 2004, hence they are
not practical for this study.
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The target interest rate data of the two central banks were obtained from their
respective websites.17 Panel A of Table 3.1 reports the breakdown of target rate
announcements into rate rises, rate cuts and unchanged sub-components. From
January 1999 to December 2006, the Fed and the ECB made 69 and 131 target rate
announcements, respectively. Of these, the Fed had 19 announcements with rate
changes (13 rate rises and 6 cuts) and 50 with no changes. The ECB made 21
announcements of the target rate changes (13 rises and 8 cuts) and 110 with no
change. Thus, most of the interest rate announcements contained no change (72% for
the Fed and 84% for the ECB).
Panel B of Table 3.1 reports the summary statistics for the interest rate news
series. While 35% of the Feds interest rate announcements were correctly
anticipated, only 26% of the ECBs interest rate announcements were correct