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Financial market reaction to Federal Reserve communications: Does the global financial crisis make a difference?

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Abstract

This paper studies the effects of Federal Reserve communications on US financial market returns from 1998 to 2009 and asks whether they changed significantly during the global financial crisis of August 2007–July 2009. We find, first, that central bank communication moves financial markets in the intended direction. In particular, shorter maturities are affected in an economically meaningful way. Second, speeches by the chairman generate relatively larger market reactions than communication by other governors or presidents. Finally, central bank communication is even more market relevant during the subsample covering the global financial crisis.

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Notes

  1. In 1998, 114 speeches were delivered by FOMC members; in 2006, central bankers spoke 190 times.

  2. For every major central bank there is at least one study showing that communications other than post-meeting statements or monetary policy reports have an influence on financial markets. For instance, see Guthrie and Wright (2000) for New Zealand, Connolly and Kohler (2004) for six central banks (Australia, Canada, the European Central Bank, New Zealand, the United Kingdom, and the United States), Andersson et al. (2006) for Sweden, Reeves and Sawicki (2007) for the United Kingdom, de Haan (2008) for the European Central Bank, Hayo and Neuenkirch (2012) for Canada, and Ranaldo and Rossi (2010) for Switzerland.

  3. Uncertainty in financial markets can, for instance, be measured by the mean conditional standard deviation of a GARCH(1,1) model. Table 9 in the “Appendix” shows the estimated results. Comparing the figures for the global financial crisis period with the overall sample indicates that the former are 1.5–2 times larger, which suggests increased uncertainty. The difference is even more striking when using the tightening cycle of July 2004–June 2006 as a benchmark. Now the mean conditional standard deviation is 2–3 times larger compared to this period of (almost) perfectly predictable monetary policy.

  4. Subsamples and variants of this data set have been successfully employed in two different contexts. Hayo and Neuenkirch (2010) explain US target rate decisions using macroeconomic variables and Federal Reserve communications. They discover that communications significantly explain and predict target rate decisions and improve explanatory power over a Taylor (1993) rule. Hayo and Neuenkirch (2013) use US regional and national macroeconomic variables to explain the content of these communications. They find that the opinions expressed by Fed governors and presidents can be described by a Taylor (1993) rule and, particularly, that regional economic conditions affect the content of presidents’ speeches.

  5. Several papers avoid making suppositions about the direction of monetary policy or the economic outlook. These papers use only the communication events, without any direction as an explanatory variable. For instance, Kohn and Sack (2004) study the effects of US central bank communication events on the volatility of financial variables. The simple idea behind this approach is that if communications affect the returns on financial assets, the volatility of these returns should be higher on days of central bank communications. This approach is less prone to mistakes by the researcher or misinterpretation by financial newswires, but its obvious drawback is that there is no control for whether markets move in the correct (or intended) direction. Additionally, equality restrictions between different types of news are set, so that one cannot distinguish between possibly larger reactions to bad than to good news. Finally, higher volatility can be an indication of (1) higher noise reflecting uncertainty or (2) actual news requiring traders to alter their behaviour.

  6. Speeches without any information on monetary policy stance or economic outlook and speeches with ‘neutral’ content are coded as non-events.

  7. An alternative to subjective coding is using content analysis software (e.g., Lucca and Trebbi 2009). However, communications other than post-meeting statements are not standardised and thus content analysis programs fail to detect all relevant systematic patterns in these much more complex texts.

  8. The coding was done by the third author and two research assistants. Unclear cases were also discussed with the first author.

  9. In the “Appendix”, we provide a few examples of speeches along with our classification of them.

  10. According to the median of the Reuters poll of professional economic observers, financial market participants were surprised by an interest rate cut on nine occasions in our sample, whereas the Fed unexpectedly raised its target rate only four times. .

  11. Data sources: bond and foreign exchange market series—Federal Reserve’s Statistical Releases H10 and H15; stock market series—Yahoo! Finance database.

  12. We chose daily data instead of intra-day data for two reasons. At a conceptual level, we are interested in whether there are economically important effects that persist over time instead of just picking out short blips in the data. Even though the scheduled delivery time of speeches is recorded at the central bank’s website, it is not possible to time the central bank news precisely in 5-min time intervals, as can be done for newswire reports.

  13. Estimation within an EGARCH framework (Nelson 1991) was not possible, as the algorithm did not converge. Doornik and Ooms (2008) suggest that the presence of dummy variables could cause such problems.

  14. The contemporaneous other market returns are omitted to avoid simultaneity problems.

  15. The surprise component of macroeconomic announcements is constructed by subtracting median market expectations (obtained through a Reuters survey of market participants) from the actually released figure. To ensure comparability, we standardise the surprise component by its respective standard deviation.

  16. The mean of the Reuters poll of professional economic observers is used to identify surprises that occur during scheduled meetings. Intermeeting moves are naturally classified as surprises. For instance, a ‘surprise hike’ can be (1) an unexpected rise in the target rate or (2) an unchanged target rate when a rate cut was expected.

  17. The coefficients can be interpreted as follows: 0.016 denotes an increase of 3-month bonds by 1.6 bps after a one standard deviation shock in NFP +; −0.123 denotes a decrease by 12.3 bps after a 25 bps target rate surprise cut; 0.027 denotes an increase by 2.7 bps after a hawkish speech delivered by the chairman.

  18. All except three coefficients (‘ISM −’ on the stock market and ‘Discount Rate’ on the 1- and 5-year bond market) show the expected sign.

  19. Statistical tests confirm this result for 3-month bonds (Chairman MP − vs. Voting Pres. MP −: Chi2(1) = 14.5**; Chairman MP − vs. Nonvot. Pres. MP −: Chi2(1) = 18.6**). For the longer maturities, we find larger point estimates for the chairman.

  20. Three-month bonds: Chairman MP + vs. Chairman MP −: Chi2(1) = 5.8*.

  21. August 2007 is a good starting point for our definition of the financial crisis period, since it was at that point that problems in the US subprime mortgage market started spilling over into other financial markets. The Fed announced on 10 August 2007 that it ‘will provide reserves as necessary … to promote trading in the federal funds market at rates close to the FOMC’s target rate of 5.25 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding’. We choose July 2009 as an end point for the financial crisis period, as the most severe problems associated with the financial turbulence had by then subsided in the United States. This choice is supported by Ben Bernanke’s semi-annual Monetary Policy Report to the Congress on 21 July 2009, in which he testified that ‘the extreme risk aversion of last fall has eased somewhat, and investors are returning to private credit markets’. However, the global financial crisis of August 2007–July 2009 was accompanied and followed by a severe economic crisis in the US with unemployment rates being above 8 percent until August 2012. Therefore, one could consider the period after July 2009 as crisis period, too. Due to data limitations we stick to our definition and leave a more detailed analysis of monetary policy communications at the zero lower bound of interest rates as an interesting task for future research.

  22. Table 11 in the “Appendix” summarises the frequency of communication events in the global financial crisis subsample.

  23. Note, however, that we find no statistically significant differences for those communication variables which are significant both in the estimations utilising the full sample and the financial crisis subsample (3-month bonds: Statement MP −, Chairman MP −, Voting Pres. MP −, Nonvot. Pres. MP −; 6-month bonds; Statement MP −, Nonvot. Pres. MP −).

  24. Statistical tests confirm this finding for 3-month bonds (Chairman MP − vs. Voting Pres. MP −: Chi2(1) = 3.9*; Chairman MP − vs. Nonvot. Pres. MP −: Chi2(1) = 6.1*) and 6-month bonds (Chairman EO − vs. Oth. Govern. EO −: Chi2(1) = 11.8**).

  25. To conserve space, we do not report the estimation results, but they are available on request.

  26. Whether this tendency of target surprises rather than path surprises holds for the more recent years is unclear to us. Presumably, with short-term interest rates stuck at the zero lower bound since end-2008, Fed communications might more likely lead to path surprises since then.

  27. Three-month bonds: Chairman MP +, Chairman MP −, Nonvot. Pres. MP −; 1-year bonds; Chairman MP +; S&P 500: MPR/Test. EO −.

  28. However, these communications contain valuable information, for instance, with respect to future interest rate decisions (see Hayo and Neuenkirch 2010).

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Acknowledgments

We thank two anonymous referees, Ari Belasen, Michael Ehrmann, Michael Lamla, participants of the Annual Conference of the Eastern Economic Association in New York, the Verein für Socialpolitik in Graz, MAREM workshop in Bonn, and research seminars at the Universities of FU Berlin, UL Brussels, Cardiff, Duisburg-Essen, and Marburg for their helpful comments on earlier versions of the paper. The usual disclaimer applies.

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Authors and Affiliations

  1. Philipps-University Marburg, Marburg, Germany

    Bernd Hayo

  2. Southern Illinois University Edwardsville, Edwardsville, IL, USA

    Ali M. Kutan

  3. The Emerging Markets Group, London, UK

    Ali M. Kutan

  4. William Davidson Institute, Ann Arbor, MI, USA

    Ali M. Kutan

  5. Department of Economics, University of Trier, 54286, Trier, Germany

    Matthias Neuenkirch

Authors
  1. Bernd Hayo
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  2. Ali M. Kutan
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  3. Matthias Neuenkirch
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Correspondence to Matthias Neuenkirch.

Appendix

Appendix

1.1 Examples of speeches and their coding

1.1.1 Remarks by Chairman Alan Greenspan before the Economic Club of New York (24 May 2001)

Moreover, with inflation low and likely to be contained, the main threat to satisfactory economic performance appeared to come from excessive weakness in activity. … The period of sub-par economic growth is not yet over, and we are not free of the risk that economic weakness will be greater than currently anticipated, requiring further policy response.

Coding: Speech Alan Greenspan EO negative/Alan Greenspan MP easing.

1.1.2 Testimony of Chairman Alan Greenspan before the Joint Economic Committee, US Senate (21 April 2004)

After having risen at an annual rate of 2 1/2 percent in the first half of last year, real GDP increased at an annual pace of more than 6 percent in the second half. … Although real GDP is not likely to continue advancing at the same pace as in the second half of 2003, recent data indicate that growth of activity has remained robust thus far this year. … As I have noted previously, the federal funds rate must rise at some point to prevent pressures on price inflation from eventually emerging.

Coding: Testimony Alan Greenspan EO positive/Alan Greenspan MP tightening (see Tables 9, 10, 11).

Table 9 Mean conditional standard deviations
Full size table
Table 10 Descriptive statistics of daily returns
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Table 11 Number of non-zero values for communication dummies (global financial crisis period)
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Hayo, B., Kutan, A.M. & Neuenkirch, M. Financial market reaction to Federal Reserve communications: Does the global financial crisis make a difference?. Empirica 42, 185–203 (2015). https://doi.org/10.1007/s10663-014-9258-y

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