Impact of Monetary Policy Surprises in the German and US Markets

Abstract

Is your time best spent reading someone else’s essay? Get a 100% original essay FROM A CERTIFIED WRITER!

Save 25%

This paper seeks to make an investigation on the impact of monetary policy surprises in the German and United States markets. This paper will show that the volatility of the stock returns is susceptible to the monetary policies in the United States. In the Euro zone, monetary policy surprises matter for the bond return volatility. This paper finds results that are robust for the Euro zone stock markets, but not necessarily for other Euro zone bond markets. The research paper reveals that surprises in monetary policies have a great effect on the German stock return volatility in the bear phase of the market than the bull phase (Gagnon, Raskin, Remache and Sack, 2011). Additionally, the results of the research indicate a support of the claim that the stock return volatility is negatively correlated with the stock returns. This claim contradicts the predictions that are made by the many asset pricing models such as the CAPM and the ICAPM.

Introduction

This paper makes an examination of the effect of the monetary policy surprises, especially on the international bond returns, with particular focus on the Euro zone and the American markets. The paper also decomposes the international bond returns within the (Barakchian and Crowe, 2010). into news regarding the future returns, future inflation rate and the real interest rates. The manner in which interest rates respond to the Federal reserve actions has for long been a topic of huge discussions and has drawn interest from a large array of participants and policy makers. The natural concerns of the bondholders is the effect of the Fed reserve policy on the prices of bonds. More often than not, the first link of transmission of the Federal Reserve policy is from the Fed funds target to the various interest rates. This issue, the transmission, is often very vital in the assessment of the likely effectiveness of the monetary policies implemented by a government.

Monetary Policy Overview

In the contemporary world and Federal policy understanding, an increase in the target funds rate often leads to a corresponding increase in the market interest rates. This increase is often the result of changes in interest rates by the commercial banks. According to a research done by Eichengreen and Mody (2010), there is a very little or almost no effect of the Federal policies on the rates of interests. The study asserts that the relationship between the Federal policies and the long term interest rates are rather loose and more variable than being intact and fixed. The studies, however, did not make a distinction between the expected and unexpected actions and this failure purportedly led to the lack of close link between these two phenomena. This paper makes an effort to show that the response of the interest rates to the surprise nature of the Fed policy is stronger than the response to the change in the target itself. Amusingly, the rates response to the Fed policy changes remain uniform and minimal, supporting an argument that a short term structure contains little information about future changes of the short-term rates (Cochrane and Piazzesi, 2002).

In the United States, there has been a lot of research, particularly in macroeconomics that look at the effects of the unconventional monetary policy actions. These studies focus both on the impact on the monetary policy issues and the financial asset prices. The Federal Reserve unconventional monetary policy actions often have an impact on overseas markets. Though there is a relatively little evidence to relate the strength and the scope of this spillover to the effects on the different markets, there are indicators to show that these changes do have some effects. This paper systematically quantifies these differences in the transmission of the United States monetary policies to the international bond markets.

In the traditional monetary policy transmissions, without surprises, there are two main considerations that motivate a revisit to the classical topic of monetary policies. The first consideration is the looks at the conventional models of monetary policy transmissions that treat the financial market with a lot of ease. This model is, however, criticized and is perceived to need rethinking due to the recent economic crisis. Secondly, these smooth frameworks have sharp predictions that show how credit costs should change in response to monetary policy actions. This effect is particularly felt in the borrowing rates.

Identification of Monetary policy

Monetary policy is majorly concerned with the actions of the central bank and (or) other regulatory authorities that are responsible for the determination of the size and the rate of growth of the supply of money. In the United States, the Federal Reserve is in charge of the monetary policy, and it is implemented majorly by applying actions and operations that have short-term influence on the rates of interest. Monetary policy in the U.S is determined and controlled by the Federal Reserve which is responsible for provision of the bank functions. There are three main ways in which the Federal Reserve can manipulate the money supply. One of the most basic is the buying and selling of the treasury securities. Selling the securities has an impact of reducing money supply in the market. Buying the securities, on the other hand, increase the supply of money. Secondly the Federal Reserve can change the discount rates. Finally the Federal Reserve can adjust the requirements of the reserve which has a great impact on the money multiplier. In the United States, this adjustment is done infrequently, and the last one was done in 1992. Germany, as a country, does not have its own money. As a result, they cannot use their own monetary policy. This condition compels her to abide by what the European Central Bank says.

There are issues that are necessary if addressed during the study of the influence of the changes in monetary policies in the bond market. These issue can be classified into three broad areas;

Endogeneity

Omitted variable bias, and

Deriving a measure of the surprise component of a policy rate change.

The right identification of changes in policy can best be seen in early studies that make assessments to the impact of the changes in money supply on the prices of assets. These changes can often be used as clear indicators of the demand and supply of money. On the other hand, a failure to properly identify and point out the monetary changes has the potential of leading to spontaneous changes. The issues that come with the identification of the changes to the monetary policy become clearer at the point where researchers focus on the short term rates as the main policy variable of the Central banks. Researchers often take note that whereas is important to isolate the influence of the change of policy rates on the prices of assets, mainly for easy studies, it is possible that this causation may run in the opposite directions, such that the changes in the prices lead the monetary policy to change the policy rates. Nakamura and Steinsson (2013) made an attempt to control the possibility of policy changes having an influence on asset prices. They, however, found out that the impacts of a failure to take into account the changes in monetary policy are small in practice.

There are a number of theories that have been put forward to explain the impacts of monetary policy changes. These theories are mostly based on the assumptions that efficient markets such as the American markets would make suggestions that only the anticipated and expected changes in policy should have an immediate effect on the asset prices. As such, a change in asset prices are expected to respond to the changes in policy rate changes only to the surprise elements of the changes made. The elements of anticipation in this case should have already been priced into the assets values before. There are some empirical work that fail to break the monetary policy changes into the expected and unexpected subcategories of components that will most likely to lead to biased results. One of the most common ways that is used to make a distinction between the surprises and the expected changes in the monetary policy is to make use of the futures market data. This way comes out of the fact that futures data market have been on a dramatic increase in both the liquidity and the range of the instruments on offer. Therefore, one can easily derive the measure of the surprise elements on a continual basis and this is the approach that is adopted by this paper.

Review of previous studiesOne of the first papers that made an asses...