RDP 2004-10: News and Interest Rate Expectations: A Study of Six Central Banks 2. News and Interest Rate Expectations: Some Conceptual Issues

Many asset prices incorporate, among other factors, expectations about the future path of monetary policy. The most direct measure of expected future policy rates are interest rate futures, since these incorporate expectations of market interest rates, which are closely linked to the policy rate over the short to medium horizon. Over this horizon, movements in interest rate futures mainly reflect revisions in market expectations regarding the future path of monetary policy.^[1]

The efficient market hypothesis suggests that interest rate futures incorporate all relevant information about future interest rates that is available at any point in time. As a consequence, a variable that can be forecast perfectly will have no measurable effect on changes in interest rate futures. This, however, does not mean that the variable is unimportant for monetary policy setting, but it means that expectations will not significantly change following the release of news on such a variable. As a result, the literature on the movement of financial markets in response to news releases usually focuses on the surprise element in the data (see, for example, Fleming and Remolona 1997).

Potentially, any type of news event that can convey information on the future path of monetary policy can affect interest rate expectations. For example, the yield curve should be influenced by both policy-related events such as meetings of the committee or board that sets policy rates and by the release of macroeconomic news. Central bank communication more generally can provide new information to the extent that it helps the markets to interpret the relevance of macroeconomic developments for the decision-making process. Consequently, in this paper we look at four types of news:

• domestic macroeconomic news, comprising domestic macroeconomic data releases;
• foreign news, comprising data releases and policy decisions in important international markets;
• monetary policy news, that is (domestic) monetary policy decisions; and
• central bank communication, including regular reports, parliamentary hearings, press releases, minutes of meetings and speeches.

Estimating the effect of macroeconomic news on interest rates is relatively straightforward. The widely used approach in the event-study literature is to estimate the daily change in the interest rate futures as a function of macroeconomic surprises (see, for example, Jansen and de Haan 2003, and Kohn and Sack 2003). The surprise element is measured by taking the difference between the actual outcome of macroeconomic news releases and the outcome expected in a survey of market economists.^[2]

Developments in important foreign markets, especially the US, appear to have a major impact on all asset classes in other economies. Consequently, in a number of studies foreign news has been identified as an important determinant of domestic interest rate futures. Some of these studies account for foreign news by explicitly considering the effect on domestic interest rate futures of foreign policy decisions and a number of selected foreign data releases (see, for example, Campbell and Lewis 1998, and Gravelle and Moessner 2001). Others have modelled domestic and foreign interest rate futures jointly, thus accounting for linkages between economies (for example, Ehrmann and Fratzscher 2002, and Kim and Sheen 2000). In this paper, we assume that any important development in the foreign market must be reflected in a change of the foreign interest rate futures. These changes in foreign interest rate futures can therefore be seen as a proxy for both foreign macroeconomic data releases and foreign policy surprises.

Estimating the effect of monetary policy surprises on interest rates has been the subject of numerous studies on the predictability of monetary policy (see, for example, Bomfim and Reinhart 2000, Haldane and Read 2000, Kuttner 2001, Lange, Sack and Whitesell 2001, Muller and Zelmer 1999, and Ross 2002). In these studies, monetary policy surprises are typically defined as the change in the 30-day interest rate on the day of announcement, which is shown to be very closely related to the change in the expected policy rate over the following month. In a recent study, Coppel and Connolly (2003) compare the predictability of monetary policy across a panel of central banks. Table 1 replicates their results, updated to June 2004, the endpoint of the dataset used in our study. The coefficients reported measure the response of the 30-day interest rate to monetary policy moves. A coefficient of zero implies that monetary policy is, on average, fully predictable, and there are no policy surprises. A non-zero coefficient measures the size of the surprise element per basis point increase in the policy rate, on average.

The results confirm Coppel and Connolly's conclusion: the predictability of monetary policy is very similar across these central banks. This suggests that, despite differences in the communication framework, central banks in these economies convey information to financial markets to a very similar degree. Our study expands on these results by looking in more detail at the different communication channels that influence financial markets' expectations of future monetary policy.

Estimating the effect of central bank communication on expectations of monetary policy has been the subject of only a few studies. While there is a substantial body of theoretical literature (for recent reviews of the literature, see Geraats 2002 and Hahn 2002), the empirical literature on this topic is relatively recent, partly because it is difficult to measure the impact of monetary policy communication on interest rate expectations. To determine the effect of communication on interest rate futures directly would require a measure that can summarise and quantify the information contained in a communication event. However, sometimes it might even be difficult to establish the direction in which a certain communication event should influence interest rate expectations. One way of measuring the impact of policy news, irrespective of the direction of movement, is to examine the variance of interest rate futures on the day, since any change in the mean will also affect the variance on the same day. A specific type of communication can then be associated with a dummy variable that can take the value of one on days where such a communication event happens and zero otherwise.^[3] This approach is consistent with Kohn and Sack (2003), who look at the effect of communication on expectations in the US, Chadha and Nolan (2001) who examine the UK, and Campbell and Lewis (1998) who include an ‘RBA commentary’ variable in their study of changes in Australian interest rate futures.

An interesting question is whether increased variance on the day of central bank communication should be viewed as good or bad. While Chadha and Nolan characterise higher variance as bad, Kohn and Sack assume that increased variance is evidence that central bank communication conveys important information to market participants. We take the view that if central bank communication is to have any influence on expectations, this must show up as an increase in the daily standard deviation on days of communication. However, it is possible for some communication to be poorly worded or misinterpreted, which could be viewed as causing unnecessary volatility in financial markets. Therefore, since we cannot compare the intention of the central bank with the markets' reaction to the communication, we are only measuring whether a channel of communication has the effect of providing information to market participants, irrespective of whether that information is necessary or accurate.

Our study shares a number of features with earlier studies that estimate the effect on interest rate expectations of different types of news relevant to the future path of monetary policy. We examine daily changes in interest rate futures, though concentrate on the futures one to eight quarters ahead (Campbell and Lewis 1998 and Fleming and Remolona 1997 also analyse the long end of the yield curve). Similar to Kohn and Sack (2003) and Chadha and Nolan (2001), we estimate a model that allows us to judge the effect on both the mean and the standard deviation of the daily changes in expected interest rates. Unlike these studies, however, we estimate our results across a panel of economies. This may allow us to gain some insight into whether different types of central bank communication convey information ‘universally’.

Footnotes

In principle, a change in interest rate expectations can reflect two different channels: revisions of expectations about monetary policy settings, or revisions of expectations about the monetary policy framework, which in turn affects expectations about long-run inflation. We would expect the former to affect interest rate futures at the short to medium end of the yield curve, while the latter is more relevant for expectations of longer-term nominal interest rates. In this paper, we concentrate on the short- to medium-term expectations of interest rates, and, therefore, on news that is relevant for an assessment of monetary policy conditions over that period. [1]

Many financial time-series studies use tick-by-tick data to examine the impact of a specific event, instead of daily data. This has the advantage of being able to more easily identify the source of interest rate movements if more than one news event occurs on the day. However, this was difficult in our study for several reasons. First, a number of our communication variables, such as parliamentary hearings or speeches, have no specific time when the information content is released. Second, interest rate futures markets are not always liquid enough to examine tick-by-tick data. Finally, given the scope of our dataset, with a large number of news releases across six economies, establishing the exact timing of all data releases and communication events was not feasible. [2]

Alternatively, some studies, such as Jansen and de Haan (2003) and Andersson, Dillén and Sellin (2001), address this problem by reading each communication and making a subjective determination of whether it should have a positive or negative effect. However, it is likely to be difficult to make a judgement on the ‘intention’ of a speech on a consistent basis, especially in a cross-country study such as ours. Moreover, some communication events such as speeches can include a question and answer session, which may convey important information. Unfortunately, transcripts of such sessions are usually not available on central banks' websites. [3]