Monetary Policy, Equity Markets and the Information Effect

Abstract

Central banks analyse copious amounts of information to assess the economic outlook to then set monetary policy. So, could changes in monetary policy reveal some additional information about the economic outlook to the public? This channel is known as the 'information effect'. The information effect posits that, in addition to the usual effects of monetary policy, agents interpret an interest rate increase as signalling some additional positive economic information. This effect, if strong enough, could then lead to dynamics where an increase in interest rates causes an expansion in economic activity. I evaluate whether the information effect can be detected in Australia through the lens of equity markets. I find that, contrary to the predictions of the information effect, a surprise monetary tightening from a monetary policy announcement causes equity prices to fall. I also show that this response in equity prices is, at least in part, driven by downward adjustments in expected earnings growth. These responses are consistent with conventional views of the effects of monetary policy. However, looking beyond monetary policy announcements yields some evidence that an information effect could be present through other forms of Reserve Bank of Australia (RBA) communication. I find speeches delivered by the RBA Governor generate responses in equity prices and earnings forecasts consistent with the information effect. But this result appears to be the exception rather than the rule. For most monetary policy communication, at least in equity markets, the information effect is not an important channel of monetary policy.