Does The Fed Move The Market ? By: Rick Foessett

Plan Replicate part of the study done in Bernanke and Kuttner (2005) Expand sample through 2005 Run regressions using their sample, extension of sample, and then combined sample.

Goals of Monetary Policy: 1.) High Employment 2.) Economic Growth 3.) Price Stability 4.) Interest-rate Stability 5.) Stability of Financial Markets 6.) Stability in Foreign Exchange

Extra Special Attention 1.) High Employment 2.) Economic Growth 3.) Price Stability 4.) Interest-rate Stability 5.) Stability of Financial Markets 6.) Stability in Foreign Exchange

Price Stability Important because: -Rising prices = Uncertainty -Uncertainty slows economic growth. Ex: Depletion of purchasing power -Feel need to spend today -Less money available leads to less investment.

Interest-rate Stability Fluctuating rates = Uncertainty -Uncertainty complicates planning for the future. Ex: Factory expansion -Volatile rates affect project 2 ways: 1.)Financing the project 2.)Feasibility of the project

Interest-rate Stability Financing the project: -Companies rarely self-finance 100%. -Two sources of funds: 1.) Bank loans 2.) New bond issue

Interest-rate Stability Bank Loans -Uncertain rates make banks nervous for two reasons: 1.) If rates climb, banks lose potential income on money lent out at lower rates. 2.) Business could have trouble selling goods, which equates to greater risk.

Interest-rate Stability Banks have two options: 1.) Do not lend any money. -Less lending= Less revenues 2.) Lend at a higher interest rate. -Higher rate means more cost to the business. -Is project still feasible?

Interest-rate Stability New Bond Issue -Investors require a higher rate of return. Why? -1.) Higher rate equals more risk -2.) Put money somewhere else.

Interest-rate Stability Feasibility of the project -Run a cost benefit analysis (CBA) Uncertainties within the CBA: 1.) How much to produce? 2.) What is the sales price?

Interest-rate Stability In a stable environment a company can more easily forecast the demand for their good and price at which it can be sold, making the process of predicting revenue streams easier. In an unstable environment there is a lot of uncertainty, which can lead to a hold on the project. Hold on project *hundreds of projects means less economic growth.

Interest-rate Stability Consumption point of view. -Uncertainty makes both business and individual consumers postpone purchases due to: 1.) Increased cost of credit 2.) Greater return on savings -Reducing economic growth.

Fed Tools Aware of the consequences of unstable prices and rates, the Fed has 3 tools: 1.) Fed Funds Rate (FFR) 2.) Discount Rate 3.) Reserve Requirement -Using these cause externalities

Why am I interested? Business programs always talking about the Fed and what he is going to do next. Retirement savings in the market

Why is this topic important? While it is important to know the effects of Fed action on business cycle smoothing, it is also important to understand the effect of Fed action on individual wealth. The “Wealth Effect” increases consumer spending, thus increasing economic growth.

Why is this topic important? Studying the effects of the FFR change on the stock market could also help individual stock owners plan their future trading strategies. -If investors know that increasing FFR, decreases value of their stock holdings, then might be more inclined to sell before a rate hike and vice versa.

Literature Review Previous studies have shown that changes in the federal funds rate only affect stock market returns if the change in the FFR was unexpected. Why is this? -Stock prices reflect investors’ expectations about future earnings, so any indication of a rate change gets built into the price before a change.

Literature Review Therefore, identifying any change in the value of the stock market, due to a change in the FFR, consists of separating the expected and unexpected components of the policy action. One process to do this, and the one used in this study, was designed by Kenneth Kuttner.

Literature Review Cook and Hahn (1988) Study how a change in the FFR affects interest rates. They noticed that between , the Fed’s control on the FFR had become so tight, on a day to day basis, that changes were easily recognizable.

Literature Review They used this transparency in FFR movement to determine what effects these changes had on the 3-month, 6-month, 12- month T-bills, along with changes in the 3- year, 5-year, 7-year, 10-year, and 20-year bonds. They found that changes in the FFR cause significant changes in short-term rates, moderate changes in intermediate rates, and smaller changes in long-term rates.

Literature Review Real importance is the model used:

Literature Review Krueger and Kuttner (1996) Looked at the role played by the Fed fund futures data, and how well it anticipates the changes in the FFR. Using a sample covering , they evaluate the federal funds rate futures market’s one-month and two-month ahead forecasts of the fund rate. They determined that the Fed funds futures rates yield accurate and dependable forecasts of und rate changes.

Literature Review Kuttner (2001) Shows that interest rates respond significantly stronger to the “surprise” component of Fed policy, while the anticipated component has little response. This process is the backbone for many papers. More details on process later.

Literature Review Guo (2002) Looks at the stock market and how changes in the FFR affect stock prices. Studies periods covering and Uses slightly different method than Kuttner to differentiate the expected and surprise components, but comes up with the same conclusion.

Literature Review Bernanke and Kuttner (2005) Look at stock market’s reaction to Fed policy. Found on avg., an unanticipated 25- basis point cut in the FFR is associated with approx. a 1% increase in broad stock indexes. Sample consists of days with a change in the FFR, and all dates of FOMC meetings.

Literature Review Excluded six outlier dates, and got same results, but less robust. Looked at days in which expected changes did not occur. Found a small response. Roley and Sellon (1998) found a similar response.

Analysis Sample June December Consists of all of the rate changes and FOMC meeting dates during that period, except for September 19, Measure of surprise can be calculated from the change in the futures contract’s price relative to the day prior to the policy action. This is an event-study analysis.

Analysis Figuring the unexpected component: Where is the unexpected target rate change,Is the current, or spot month, futures rate, and D is the number of days in the month. The expected component is defined as the actual change minus the surprise, or

Analysis To prevent month-end noise in the effective funds rate, the unscaled change in the 1-month futures is used instead of the spot rate. If change occurred on the first day of the month, the 1-month future rate from the previous month is used as well of the spot rate for the current month.

Analysis Model #1: whereis the return in the stock market, due to a change in the the federal fund rate, or.

Analysis Model #2: Where Is the expected funds rate changeis the unexpected rate change.

Analysis Results:

Analysis Results:

Analysis Conclusion: -When the new data was added there was not really much of a change. -Results still consistent with Bernanke and Kuttner’s conclusion in their paper. -New data on its own does not come up with anything significant. 1.) Small data set 2.) Small variation b/c transparency.

Analysis Conclusion cont’d: The main thing to take from this paper for somebody with no previous knowledge on the subject is that the stock market only responds to unexpected rate changes in the FFR. The transparency from the Fed, helps to smooth stock market fluctuations w.r.t. changes in the FFR.