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Money supply announcements, interest rates, and foreign exchange
Joumal of Znkmationaf Money and Finanre (1982) 1,201-208 0
1982 Buncrworths
Money Supply Announcements, Interest Rates, and Foreign Exchange BRADFORD CORNELL* Graduate School of Management, Univerrity of Calfornia, Los Angeies CA 90024, USA
This paper presents a test of the joint hypothesis that money supply announcements affect the real interest rate and that changes in the real interest rate affect the exchange rate in the short run. The test results are consistent with the joint hypothesis. For example, it is found that announcement of an unexpected jump in the money supply is accompanied by an increase in interest rates and an appreciation of the dollar. If the rise in interest rates was entirely due to higher inflationary expectations, the dollar should not appreciate.
Recent research by Cornell (1982), Grossman (1981), and Urich and Wachtel(l981) has revealed a significant positive correlation between unexpected changes in the money supply and changes in interest rates. In addition, Cornell (1982) found that the magnitude of the correlation rose sharply after the Federal Reserve’s announced change in operating procedure on 6 October, 1979. Two hypotheses have been offered to explain the correlation. According to the first interpretation, an unexpected increase in the money supply leads agents to expect the Fed to respond by tightening in order to prevent the money stock from growing faster than planned. Anticipating that future monetary restraint will lead to higher real interest rates, agents bid aggressively for funds in the spot market and the interest rate rises. Henceforth, I will use Urich and Wachtel’s terminology and refer to this hypothesis as the ‘policy anticipation effect’. The hypothesis is fundamentally Keynesian because changes in :lominal interest rates are due to variation in the real rate caused by changes in the supply of money. The new twist is that on announcement day the interest rate responds not to an actual change in the money stock, but to the expected future change. The second interpretation can be loosely referred to as ‘monetarist’. In response to an unexpected increase in the money supply agents are viewed as revising upward their estimates of the expected rate of inflation. According to this view the * I would like to thank Michael Darby, Ken French, Doug Joines, Richard Roll and participants at the UCLA money workshop for helpful comments.
202
Money suppb
Announcements,
Interest
Rater, And Foreign
Exchange
change in the nominal rate occurs because the inflation premium built into interest rates is adjusted. The presumption is that the impact on the real rate is small compared to the change in the inflation premium. The two views cannot be distinguished by examining the reaction of short-term rates to money supply announcements, because both predict the same response. By using data from other markets, however, it is possible to test the competing hypotheses. One possibility is to examine the response of the entire term structure to money supply announcements. This is the approach taken in Cornell (1982). While rates on short-term securities may climb in response to expected future monetary restriction, rates on long-term bonds should not respond so strongly and may even decline if money is neutral in the long run. This paper takes a different approach and makes use of data from the foreign exchange market. ’ As such it is a joint test of the hypothesis that money supply announcements affect the real rate and of competing models of the determination of exchange rates. The foreign exchange model that corresponds with the monetarist explanation of the reaction of interest rates to money supply announcements is the monetary theory of the balance of payments derived by Johnson (1975) and refined by Frenkel (1976). The analysis relies on the assumption that goods markets are perfect both domestically and internationally. This means that the price level adjusts instantaneously to clear the money market and that the exchange rate adjusts to maintain purchasing power parity.2 It also means that monetary shocks affect the exchange rate only through their impact on prices or inflationary expectations. It is easy to see that the monetary model of the balance of payments implies that changes in the dollar price of foreign exchange will be positively correlated with announced money supply innovations. In response to an unexpected increase in the money supply, for example, the expected rate of inflation will rise, driving up nominal rates. The increase in nominal rates reduces the demand for money causing the US price level to rise and the dollar to depreciate (or the price of foreign exchange to rise). Dornbusch (1976) was the first to extend the monetary theory of the balance of payments by allowing goods prices to be sluggish. Though the price level responds with a lag in Dornbusch’s model, asset prices adjust instantaneously, so adjustment of the interest rate is required to clear the money market. An increase in the money supply, for instance, causes the real rate of decline just enough to produce an offsetting increase in money demand. The decline in the real rate, in turn, causes an incipient capital outflow which leads to a short-run depreciation on the dollar. Combining Dornbusch’s model with the policy anticipation effect leads to the prediction that announced innovations in the money supply will be negatively correlated with changes in the price of foreign exchange. When an unexpected jump in the money supply is announced the ex-ante real rate rises and the dollar appreciates (so the price of foreign exchange falls). Recently, Frankel (1979, 1980) has derived a general model which includes the work of Frenkel and Dornbusch as special cases. In Frankel’s model the long-run equilibrium exchange rate adjusts to maintain purchasing power parity, but changes in the real rate cause short-run deviations of the exchange rate from its long-run path. Frankel then demonstrates that changes in nominal interest rates have opposite short-run effects on the exchange rate depending on whether the change is due to variation in the real rate or variation in the expected rate of
BRADFORD CORNELL
203
inflation. An increase in the nominal rate associated with a rise in the real rate causes the dollar to appreciate, while an increase in the nominal rate associated with rising inflationary expectations causes the dollar to depreciate.3 In summary, current theory suggests that the hypothesis that money supply announcements affect the ex-ante real rate can be tested by examining the reaction of foreign exchange rates to the announcements. AIf the monetarist view is correct, and the real rate is largely unaffected by money supply announcements, the dollar should depreciate on days when unexpected increases in the money supply occur. On the other hand, the Keynesian model predicts that unexpected increases in the money stock will cause the real rate to rise and the dollar to appreciate. I. Data and Empirical
Results
Each week since September 1977 Money Market Services of San Francisco has conducted a survey of money market traders and economists and compiled their forecasts for the change in MlB (or previously Nl). Between fifty and sixty individuals are surveyed each week, and the survey group represents a cross-section of money market participants. The survey is taken on Tuesdays for the money supply announcement due at the end of the week. (Prior to February 1980 the money supply announcements were on Thursday afternoons. Subsequently, the announcements have been on Friday afternoons.) Previous work has shown that the iMoney Market Services data are good measures of expectations. Grossman (1981) found that the forecasts were unbiased and efficiently discounted the information available to market participants on Tuesday. Engel and Frankel (1982) showed that the forecasts could not be improved by making use of interest rate and exchange rate quotes from the Wednesday and Thursday following the survey. Finally, Cornell (1982) found that the forecast errors derived from the survey data were more highly correlated with changes in interest rates than the residuals from an ARIMA model constructed from the series of weekly money supply announcements. This indicates that the survey responses reflect the information contained in the autoregressive history of the money supply series and incorporate other information as well. For these reasons the difference between the announced change in l&IlB and the survey median is used to measure the unexpected component of money supply announcements. The exchange rate data were provided by the International Monetary Market of the Chicago Mercantile Exchange which obtained them from Continental Illinois Bank. The data consist of daily bid quotes, as of 1 p.m. EST, for the British pound, the Canadian dollar, the German mark, the Japanese yen, and the Swiss franc. The interest rate data were provided by the Federal Reserve Bank of San Francisco and consist of daily bid quotes, as of 3:30 p.m. EST, on 3-month Treasury bills. The variables used in this study are the series of unexpected changes in the money supply, expressed as a percentage of the money supply, and corresponding changes in Treasury bill rates and exchange rates. Because the money supply figures are announced at 4:lO p.m. EST, changes in interest rates and exchange rates are measured from the close before the announcement to the close after the announcement. The exchange rate changes are stated in percentage terms, while the change in the Treasury bill rate is stated in basis points. The sample begins on 11 October, 1979 and runs through 12 December, 1981 for
204
Money Suppb Announcements, Interest Rates, and Foreign Exchange
a total
of 115 observations. 11 October was chosen as the starting point because previous research by Cornell (1982) has shown that the correlation between announced innovations in the money supply and changes in interest rates increased significantly after the Fed’s change in operating procedure on 6 October. Summary statistics for the data are presented in Table 1. Notice that the standard deviation of the exchange rate is nearly 1 per cent per day for all currencies except the Canadian dollar and that the standard deviation is generally about ten times the mean change and the mean forward premium in every case. This is consistent with Frenkel’s (1981) observation that nearly all of the short-run variation in exchange rates is unexpected. Because the expected change explains only about 1 per cent of
TABLE 1.
Variable UM DTB DDM DSF
DJY DBP DCD
Summary statistics:” 11 October,
Mean
St. Dev.
0.059 6.710 0.036 0.059 0.077 -0.042 -0.050
0.573 41.200 0.910 0.958 0.890 0.775 0.291
Rem
pl
p2
0.031 0.045 0.009 -0.028 -0.013
-0.07 0.11 0.09 -0.02 -0.01 -0.01 -0.01
0.03 0.12 0.04 -0.05 -0.11 0.08 -0.13
1979-12
p3 -0.04 0.14 0.03 0.00 -0.23* 0.04 -0.19*
December,
P$
Pj
0.23* 0.07 - 0.03 0.04 0.09 -0.11 -0.12
0.06 -0.07 -0.09 -0.05 0.04 -0.08 0.12
a All changes measured from close to close surrounding announcement b The Q statistic is based on first 20 autocorrelations. N = Number of observations. U&I = Unexpected change in the money supply (per cent). DTB=Change in the 3-month Treasury bill rate (in basis points). DDbl=Percentage change in the dollar price of German marks. DSF=Percentage change in the dollar price of Swiss francs. DJY=Percentage change in the dollar price of Japanese yen. DBP=Percentage change in the dollar price of British pounds. DCD=Percentage change in the dollar price of Canadian dollars. Prem =&lean forward premium expressed in percentage * Denotes significance at 5% level.
1981
Q(Wb N 45.1 24.3 28.4 16.8 14.9 22.1 24.7
115 115 115 115 115 115 115
of the money supply.
per trading day.
the variance of exchange rates on a daily basis, the change in the spot rate and the unexpected change are essentially identical. In the empirical analysis, therefore, little is lost by using the actual change in the spot rate in place of the unexpected change and avoiding the problem of measuring the daily expected change in the exchange rate. Turning to the autocorrelation functions remember that the data are daily differences in the variables observed at weekly intervals. It is not surprising, therefore, that these correlations are small. Even if there were some autocorrelation in the series of daily first differences, it is unlikely to persist for a week. The time series for unexpected changes in the money supply is also indistinguishable from white noise. The cross correlation functions are presented in Table 2. The results are consistent with the hypothesis that asset prices respond immediately to money
BRADFORD CORNELL TABLE 2.
UM UM UM UM UM UM
v. v. v. v. v. v.
DTB DDM DSF DJY DBP DCD
Cross corielatiofl
P-3
P-2
0.08 -0.01 0.05 -0.01 0.01 -0.10
0.16 -0.05 -0.01 0.06 - 0.22* -0.08
f&iciions!
full sample
PO
p1
p2
p3
0.50* -0.19* -0.18* -0.15 -0.16 -0.10
0.07 -0.03 0.01 -0.08 0.04 0.03
-0.03 0.07 0.11 0.11 0.01 0.00
0.00 0.04 0.02 0.05 -0.04 -0.17
P-l
0.08 -0.02 -0.04 -0.13 0.00 -0.04
205
’ The standard error is 0.09. Significant correlations are marked by *. supply announcements. Only one of the fifteen lagged correlations is significant at the 5 per cent level and none of the fifteen led correlations are significant. The results also confirm the strong positive relation between changes in short-term interest rates and the unexpected component of money supply announcements reported in previous studies. The contemporaneous correlation for the 3-month Treasury bill rate is 0.50, remarkably high given the noise of daily changes in money market rates. All. of the contemporaneous correlations for changes in the exchange rate are negative as predicted by the Keynesian model. For the mark and the franc the negative correlation is significant at the 5 per cent level and it is nearly significant for the yen and the pound. Because Grossman (1981) found that positive money surprises had a larger impact on interest rates than negative surprises, I also computed the correlations for positive and negative surprises separately. This procedure had little impact on the estimated correlations for the foreign exchange rates. Its main effect was to reduce the number of observations for each subsample and thus increase the standard error. To determine the magnitude of the relation, interest and exchange rate changes were regressed on the unexpected component of money supply announcements. Only the current money supply innovation was used because the cross correlation function was flat except at lag zero. The results reported in Table 3 reveal that an unexpected increase of 1 per cent in the money supply (approximately $4 billion) led to a drop of about three-tenths of 1 per cent in the price of the mark and the franc, of TABLE 3.
Y DTB DDM DSF
“JY
DBP DCD
Regression results: full sample Y,=uo+alUM,+ K
a0
t(4
al
t(a)
4.570 -0.018 -0.042 0.091 -0.029 -0.047
1.37 -0.22 -0.47 1.09 -0.40 1.73
36.210 -0.304 -0.304 -0.230 -0.220 -0.051
6.21 -2.07 - 1.97 -1.60 -1.75 - 1.07
R2 0.274 0.038 0.037 0.029 0.029 0.012
206
Money Supply Announcements,
Interest Rates, and Foreign
Exchange
over two-tenths of 1 per cent in the price of the pound and the yen, and of less than one-tenth of 1 per cent in the price of the Canadian dollar. In their study Engel and Frankel(1982) only examined the mark exchange rate over the period from October 1979 to August 1981. They report a coefficient of -0.393 on the unexpected money variable and a t-statistic of 2.71. Their findings are similar to those reported in Table 3, though the coefficient and t-statistic are slightly higher. Overall the results support the combination of Dornbusch’s model of short-run exchange rate behavior and the policy anticipation effect. How else can one explain the simultaneous rise in interest rates and appreciation of the dollar in response to announcement of an unexpected jump in the money supply? The problem is that this interpretation is not consistent with other empirical studies. For example, Fama (1975) found that based on data from 1953 to 1971 he could not reject the hypothesis that the ex-ante real return on Treasury bills was constant. Using more powerful statistical tests Hess and Bicksler (1975), Nelson and Schwert (1977) and Garbade and Wachtel(l978) showed that Fama’s conclusion was too strong by documenting variation in the ex-ante real rate. Nonetheless, all of the authors concluded that most of the variation in nominal rates was due to changing inflationary expectations. More recently, Dwyer (1981) and Mishkin (1982) have directly tested the ‘hypothesis that actual innovations in the money supply, as opposed to announcements of innovations, are negatively correlated with changes in the real rate of interest. Neither found any evidence to support the Keynesian model. But if innovations in the money supply do not affect the real rate, why should anticipation of future changes in the money supply have a significant effect on the real rate? Finally, Cornell (1982) found that the entire term structure shifted in response to money supply announcements and argued that this finding was more consistent with the monetarist view than the Keynesian interpretation. In conclusion, we are left with a puzzle. Studies using domestic interest rate data support the hypothesis that monetary innovations, and announcements of monetary innovations, primarily affect inflationary expectations and have little impact on the real rate. The foreign exchange results, however, are not consistent with this interpretation. They imply instead that money supply announcements have a larger short-run effect on the real rate than on inflationary expectations. II. Summary
and Conclusions
The positive correlation between announced money supply innovations and changes in interest rates can be explained in two ways. Either the announcement of a jump in the money stock leads to an increase in the expected rate of inflation or it leads to an increase in the real rate because of expected future tightening by the Fed. In this paper foreign exchange market data was used to test the competing hypotheses. The expected inflation view implies that announced money supply innovations will be positively correlated with changes in the price of foreign exchange, while the Keynesian model predicts a negative correlation. The findings support the Keynesian model. For all five currencies studied the estimated correlation was negative. In two cases the correlation was significant at the 5 per cent level and in two other cases it was significant at the 10 per cent level. Thus the results clearly imply that money supply announcements have a significant impact on the ex-ante real rate of interest. The problem with this conclusion is that it is inconsistent with recent studies by Dwyer and Mishkin, among others, which
BRADFORD
CORNELL
conclude that actual innovations in the money rate. If actual innovations do not affect announcements of innovations? In addition, model to explain why the entire term structure announcements. The net result is a puzzle. Domestic studies have little impact on the real rate, while the market leads to the opposite conclusion. The future research.
207
supply do not affect the ex-ante real the real rate, then why should it is difficult to use the Keynesian shifts in response to money supply indicate that monetary innovations behavior of the foreign exchange resolution of this problem awaits
Notes 1. After I had completed the research for this paper and was in the process of writing the manuscript, I received a paper from Charles Engel and Jeff Frankel (1982) which employs essentially the same approach. I have added a paragraph in the empirical section comparing my results with theirs. 2. Actually, purchasing power parity need not hold even when goods markets are perfect if relative prices are variable and consumers in different countries have different tastes. Thus the simple monetary theory of the balance of payments, which assumes purchasing power parity, is implicitly a one-good model. 3. Since Frankel’s model is carefully explained in his two articles, the details are omitted here. 4. This test was originally suggested to me by my thesis advisor, Ron McKinnon, almost 5 years ago. The Fed’s change in operating procedure, however, has made the test more interesting by increasing the correlation between money supply announcements and changes in interest rates.
References Box. G.E.P. AND G.M. JEVKINS, Time Series An&if, San Francisco: Holden-Day, 1973. CORNELL, B., ‘Money Supply Announcements and Interest Rates: Another View’, unpublished working paper, Graduate School of Management, UCLA, 1982. DORNBUSCH, R., ‘Expectations and Exchange Rate Dynamics’, 1. Pal. Econ., December 1976, 84: 1161-76. DWYER, G.P., ‘Is Variation of the Expected Real Interest Rate Unpredictable?‘,]. Monet. Econ., 1981, 8: 59-84. EDWARDS, S., ‘Floating Exchange Rates, Expectations and New Information’, unpublished working paper, Department of Economics, UCLA, 1981. ENGEL, C. AND J. FRANKEL, ‘Why AMoney Announcements Move Interest Rates: An Answer from the Foreign Exchange Market’, unpublished working paper, Berkeley: Department of Economics, University of California, 1982. FA~A, E.F., ‘Short-term Interest Rates as Predictors of Inflation’, Amer. Econ. Rev., June 1975, 65: 269-282. FAXA, E.F. AND M.R. GIBBONS, ‘Inflation, Real Returns and Capita1 Investment’, 1. Monet. Econ. (forthcoming). FRANKEL, J., ‘On the Mark: A Theory of Floating Exchange Rates Based on Real Interest Rate Differentials’, Amer. Econ. Reu., September 1979, 69: 610-622. FRANKEL, J., ‘Monetary and Portfolio-Balance Models of Exchange Rate Determination’, unpublished working paper, National Bureau of Economic Research, No. 80-7, 1980. FREXK~L, J.A., ‘A Monetary Approach to the Exchange Rate: Doctrinal Aspects and Empirical Evidence’, Scand. f. Econ., February 1976, 8: 200-224. FREVKEL, J.A., ‘Flexible Exchange Rates, Prices and the Role of “News”: Lessons from the 197Os’, 1. Pal. Econ., August 1981, 89: 665-705. GARBADE, K. AND P. WACHTEL. ‘Time Variation in the Relationship Between Inflation and Interest’, 1. Monet. Econ., November 1978, 4: 755-765. GROSSMAN, J.. ‘The Rationality of LMoney Supply Expectations and the Short-run Response of Interest Rates To LMonetary Surprises’,;l. Monv, CreditandBan&g, November 1981,13: 409-24. HESS, P,J. AND J.L. BICKSLER. ‘Capital,Asset Prices versus Time Series rModels as Predictors of
208
Monet Supp~ Announcements, Interest Rater, and Foreign Exchange
Inflation: The Expected Real Rate of Interest and Market Efficiency’,]. Fin. Econ., December 1973,2: 341-360. JOHXSON,H.G., ‘The Monetary Approach to the Balance of Payments’, 7%~Manrhcstc~ School, No. 3, 220-274, 1975. MISHKXN,F.S., ‘Monetary Policy and Long-term Interest Rates: An Efficient Markets Approach’,]. Afonet. Econ.,1981, 7: 29-33. MISHKIN. F.S., ‘Monetary Policy and Short-term Interest Rates: An Efficient Markers Rational Expectations Approach’, /. Fin. (forthcoming). NELSON, C.R. AND G.W. SCHWERT,‘Short-rerm Interest Rates as Predictors of Inflation: On Testing the Hypothesis that the Real Rate of Interest is Constant’, Amer. Econ. Rev., June 1977, 67: 478-486 URICH, T. J. AND P. WACHTEL, ‘Market Responses to Weekly Money Supply Announcements in the 197Os’,j. Fin., December 1981,36: 1063-72.
1982 Buncrworths
Money Supply Announcements, Interest Rates, and Foreign Exchange BRADFORD CORNELL* Graduate School of Management, Univerrity of Calfornia, Los Angeies CA 90024, USA
This paper presents a test of the joint hypothesis that money supply announcements affect the real interest rate and that changes in the real interest rate affect the exchange rate in the short run. The test results are consistent with the joint hypothesis. For example, it is found that announcement of an unexpected jump in the money supply is accompanied by an increase in interest rates and an appreciation of the dollar. If the rise in interest rates was entirely due to higher inflationary expectations, the dollar should not appreciate.
Recent research by Cornell (1982), Grossman (1981), and Urich and Wachtel(l981) has revealed a significant positive correlation between unexpected changes in the money supply and changes in interest rates. In addition, Cornell (1982) found that the magnitude of the correlation rose sharply after the Federal Reserve’s announced change in operating procedure on 6 October, 1979. Two hypotheses have been offered to explain the correlation. According to the first interpretation, an unexpected increase in the money supply leads agents to expect the Fed to respond by tightening in order to prevent the money stock from growing faster than planned. Anticipating that future monetary restraint will lead to higher real interest rates, agents bid aggressively for funds in the spot market and the interest rate rises. Henceforth, I will use Urich and Wachtel’s terminology and refer to this hypothesis as the ‘policy anticipation effect’. The hypothesis is fundamentally Keynesian because changes in :lominal interest rates are due to variation in the real rate caused by changes in the supply of money. The new twist is that on announcement day the interest rate responds not to an actual change in the money stock, but to the expected future change. The second interpretation can be loosely referred to as ‘monetarist’. In response to an unexpected increase in the money supply agents are viewed as revising upward their estimates of the expected rate of inflation. According to this view the * I would like to thank Michael Darby, Ken French, Doug Joines, Richard Roll and participants at the UCLA money workshop for helpful comments.
202
Money suppb
Announcements,
Interest
Rater, And Foreign
Exchange
change in the nominal rate occurs because the inflation premium built into interest rates is adjusted. The presumption is that the impact on the real rate is small compared to the change in the inflation premium. The two views cannot be distinguished by examining the reaction of short-term rates to money supply announcements, because both predict the same response. By using data from other markets, however, it is possible to test the competing hypotheses. One possibility is to examine the response of the entire term structure to money supply announcements. This is the approach taken in Cornell (1982). While rates on short-term securities may climb in response to expected future monetary restriction, rates on long-term bonds should not respond so strongly and may even decline if money is neutral in the long run. This paper takes a different approach and makes use of data from the foreign exchange market. ’ As such it is a joint test of the hypothesis that money supply announcements affect the real rate and of competing models of the determination of exchange rates. The foreign exchange model that corresponds with the monetarist explanation of the reaction of interest rates to money supply announcements is the monetary theory of the balance of payments derived by Johnson (1975) and refined by Frenkel (1976). The analysis relies on the assumption that goods markets are perfect both domestically and internationally. This means that the price level adjusts instantaneously to clear the money market and that the exchange rate adjusts to maintain purchasing power parity.2 It also means that monetary shocks affect the exchange rate only through their impact on prices or inflationary expectations. It is easy to see that the monetary model of the balance of payments implies that changes in the dollar price of foreign exchange will be positively correlated with announced money supply innovations. In response to an unexpected increase in the money supply, for example, the expected rate of inflation will rise, driving up nominal rates. The increase in nominal rates reduces the demand for money causing the US price level to rise and the dollar to depreciate (or the price of foreign exchange to rise). Dornbusch (1976) was the first to extend the monetary theory of the balance of payments by allowing goods prices to be sluggish. Though the price level responds with a lag in Dornbusch’s model, asset prices adjust instantaneously, so adjustment of the interest rate is required to clear the money market. An increase in the money supply, for instance, causes the real rate of decline just enough to produce an offsetting increase in money demand. The decline in the real rate, in turn, causes an incipient capital outflow which leads to a short-run depreciation on the dollar. Combining Dornbusch’s model with the policy anticipation effect leads to the prediction that announced innovations in the money supply will be negatively correlated with changes in the price of foreign exchange. When an unexpected jump in the money supply is announced the ex-ante real rate rises and the dollar appreciates (so the price of foreign exchange falls). Recently, Frankel (1979, 1980) has derived a general model which includes the work of Frenkel and Dornbusch as special cases. In Frankel’s model the long-run equilibrium exchange rate adjusts to maintain purchasing power parity, but changes in the real rate cause short-run deviations of the exchange rate from its long-run path. Frankel then demonstrates that changes in nominal interest rates have opposite short-run effects on the exchange rate depending on whether the change is due to variation in the real rate or variation in the expected rate of
BRADFORD CORNELL
203
inflation. An increase in the nominal rate associated with a rise in the real rate causes the dollar to appreciate, while an increase in the nominal rate associated with rising inflationary expectations causes the dollar to depreciate.3 In summary, current theory suggests that the hypothesis that money supply announcements affect the ex-ante real rate can be tested by examining the reaction of foreign exchange rates to the announcements. AIf the monetarist view is correct, and the real rate is largely unaffected by money supply announcements, the dollar should depreciate on days when unexpected increases in the money supply occur. On the other hand, the Keynesian model predicts that unexpected increases in the money stock will cause the real rate to rise and the dollar to appreciate. I. Data and Empirical
Results
Each week since September 1977 Money Market Services of San Francisco has conducted a survey of money market traders and economists and compiled their forecasts for the change in MlB (or previously Nl). Between fifty and sixty individuals are surveyed each week, and the survey group represents a cross-section of money market participants. The survey is taken on Tuesdays for the money supply announcement due at the end of the week. (Prior to February 1980 the money supply announcements were on Thursday afternoons. Subsequently, the announcements have been on Friday afternoons.) Previous work has shown that the iMoney Market Services data are good measures of expectations. Grossman (1981) found that the forecasts were unbiased and efficiently discounted the information available to market participants on Tuesday. Engel and Frankel (1982) showed that the forecasts could not be improved by making use of interest rate and exchange rate quotes from the Wednesday and Thursday following the survey. Finally, Cornell (1982) found that the forecast errors derived from the survey data were more highly correlated with changes in interest rates than the residuals from an ARIMA model constructed from the series of weekly money supply announcements. This indicates that the survey responses reflect the information contained in the autoregressive history of the money supply series and incorporate other information as well. For these reasons the difference between the announced change in l&IlB and the survey median is used to measure the unexpected component of money supply announcements. The exchange rate data were provided by the International Monetary Market of the Chicago Mercantile Exchange which obtained them from Continental Illinois Bank. The data consist of daily bid quotes, as of 1 p.m. EST, for the British pound, the Canadian dollar, the German mark, the Japanese yen, and the Swiss franc. The interest rate data were provided by the Federal Reserve Bank of San Francisco and consist of daily bid quotes, as of 3:30 p.m. EST, on 3-month Treasury bills. The variables used in this study are the series of unexpected changes in the money supply, expressed as a percentage of the money supply, and corresponding changes in Treasury bill rates and exchange rates. Because the money supply figures are announced at 4:lO p.m. EST, changes in interest rates and exchange rates are measured from the close before the announcement to the close after the announcement. The exchange rate changes are stated in percentage terms, while the change in the Treasury bill rate is stated in basis points. The sample begins on 11 October, 1979 and runs through 12 December, 1981 for
204
Money Suppb Announcements, Interest Rates, and Foreign Exchange
a total
of 115 observations. 11 October was chosen as the starting point because previous research by Cornell (1982) has shown that the correlation between announced innovations in the money supply and changes in interest rates increased significantly after the Fed’s change in operating procedure on 6 October. Summary statistics for the data are presented in Table 1. Notice that the standard deviation of the exchange rate is nearly 1 per cent per day for all currencies except the Canadian dollar and that the standard deviation is generally about ten times the mean change and the mean forward premium in every case. This is consistent with Frenkel’s (1981) observation that nearly all of the short-run variation in exchange rates is unexpected. Because the expected change explains only about 1 per cent of
TABLE 1.
Variable UM DTB DDM DSF
DJY DBP DCD
Summary statistics:” 11 October,
Mean
St. Dev.
0.059 6.710 0.036 0.059 0.077 -0.042 -0.050
0.573 41.200 0.910 0.958 0.890 0.775 0.291
Rem
pl
p2
0.031 0.045 0.009 -0.028 -0.013
-0.07 0.11 0.09 -0.02 -0.01 -0.01 -0.01
0.03 0.12 0.04 -0.05 -0.11 0.08 -0.13
1979-12
p3 -0.04 0.14 0.03 0.00 -0.23* 0.04 -0.19*
December,
P$
Pj
0.23* 0.07 - 0.03 0.04 0.09 -0.11 -0.12
0.06 -0.07 -0.09 -0.05 0.04 -0.08 0.12
a All changes measured from close to close surrounding announcement b The Q statistic is based on first 20 autocorrelations. N = Number of observations. U&I = Unexpected change in the money supply (per cent). DTB=Change in the 3-month Treasury bill rate (in basis points). DDbl=Percentage change in the dollar price of German marks. DSF=Percentage change in the dollar price of Swiss francs. DJY=Percentage change in the dollar price of Japanese yen. DBP=Percentage change in the dollar price of British pounds. DCD=Percentage change in the dollar price of Canadian dollars. Prem =&lean forward premium expressed in percentage * Denotes significance at 5% level.
1981
Q(Wb N 45.1 24.3 28.4 16.8 14.9 22.1 24.7
115 115 115 115 115 115 115
of the money supply.
per trading day.
the variance of exchange rates on a daily basis, the change in the spot rate and the unexpected change are essentially identical. In the empirical analysis, therefore, little is lost by using the actual change in the spot rate in place of the unexpected change and avoiding the problem of measuring the daily expected change in the exchange rate. Turning to the autocorrelation functions remember that the data are daily differences in the variables observed at weekly intervals. It is not surprising, therefore, that these correlations are small. Even if there were some autocorrelation in the series of daily first differences, it is unlikely to persist for a week. The time series for unexpected changes in the money supply is also indistinguishable from white noise. The cross correlation functions are presented in Table 2. The results are consistent with the hypothesis that asset prices respond immediately to money
BRADFORD CORNELL TABLE 2.
UM UM UM UM UM UM
v. v. v. v. v. v.
DTB DDM DSF DJY DBP DCD
Cross corielatiofl
P-3
P-2
0.08 -0.01 0.05 -0.01 0.01 -0.10
0.16 -0.05 -0.01 0.06 - 0.22* -0.08
f&iciions!
full sample
PO
p1
p2
p3
0.50* -0.19* -0.18* -0.15 -0.16 -0.10
0.07 -0.03 0.01 -0.08 0.04 0.03
-0.03 0.07 0.11 0.11 0.01 0.00
0.00 0.04 0.02 0.05 -0.04 -0.17
P-l
0.08 -0.02 -0.04 -0.13 0.00 -0.04
205
’ The standard error is 0.09. Significant correlations are marked by *. supply announcements. Only one of the fifteen lagged correlations is significant at the 5 per cent level and none of the fifteen led correlations are significant. The results also confirm the strong positive relation between changes in short-term interest rates and the unexpected component of money supply announcements reported in previous studies. The contemporaneous correlation for the 3-month Treasury bill rate is 0.50, remarkably high given the noise of daily changes in money market rates. All. of the contemporaneous correlations for changes in the exchange rate are negative as predicted by the Keynesian model. For the mark and the franc the negative correlation is significant at the 5 per cent level and it is nearly significant for the yen and the pound. Because Grossman (1981) found that positive money surprises had a larger impact on interest rates than negative surprises, I also computed the correlations for positive and negative surprises separately. This procedure had little impact on the estimated correlations for the foreign exchange rates. Its main effect was to reduce the number of observations for each subsample and thus increase the standard error. To determine the magnitude of the relation, interest and exchange rate changes were regressed on the unexpected component of money supply announcements. Only the current money supply innovation was used because the cross correlation function was flat except at lag zero. The results reported in Table 3 reveal that an unexpected increase of 1 per cent in the money supply (approximately $4 billion) led to a drop of about three-tenths of 1 per cent in the price of the mark and the franc, of TABLE 3.
Y DTB DDM DSF
“JY
DBP DCD
Regression results: full sample Y,=uo+alUM,+ K
a0
t(4
al
t(a)
4.570 -0.018 -0.042 0.091 -0.029 -0.047
1.37 -0.22 -0.47 1.09 -0.40 1.73
36.210 -0.304 -0.304 -0.230 -0.220 -0.051
6.21 -2.07 - 1.97 -1.60 -1.75 - 1.07
R2 0.274 0.038 0.037 0.029 0.029 0.012
206
Money Supply Announcements,
Interest Rates, and Foreign
Exchange
over two-tenths of 1 per cent in the price of the pound and the yen, and of less than one-tenth of 1 per cent in the price of the Canadian dollar. In their study Engel and Frankel(1982) only examined the mark exchange rate over the period from October 1979 to August 1981. They report a coefficient of -0.393 on the unexpected money variable and a t-statistic of 2.71. Their findings are similar to those reported in Table 3, though the coefficient and t-statistic are slightly higher. Overall the results support the combination of Dornbusch’s model of short-run exchange rate behavior and the policy anticipation effect. How else can one explain the simultaneous rise in interest rates and appreciation of the dollar in response to announcement of an unexpected jump in the money supply? The problem is that this interpretation is not consistent with other empirical studies. For example, Fama (1975) found that based on data from 1953 to 1971 he could not reject the hypothesis that the ex-ante real return on Treasury bills was constant. Using more powerful statistical tests Hess and Bicksler (1975), Nelson and Schwert (1977) and Garbade and Wachtel(l978) showed that Fama’s conclusion was too strong by documenting variation in the ex-ante real rate. Nonetheless, all of the authors concluded that most of the variation in nominal rates was due to changing inflationary expectations. More recently, Dwyer (1981) and Mishkin (1982) have directly tested the ‘hypothesis that actual innovations in the money supply, as opposed to announcements of innovations, are negatively correlated with changes in the real rate of interest. Neither found any evidence to support the Keynesian model. But if innovations in the money supply do not affect the real rate, why should anticipation of future changes in the money supply have a significant effect on the real rate? Finally, Cornell (1982) found that the entire term structure shifted in response to money supply announcements and argued that this finding was more consistent with the monetarist view than the Keynesian interpretation. In conclusion, we are left with a puzzle. Studies using domestic interest rate data support the hypothesis that monetary innovations, and announcements of monetary innovations, primarily affect inflationary expectations and have little impact on the real rate. The foreign exchange results, however, are not consistent with this interpretation. They imply instead that money supply announcements have a larger short-run effect on the real rate than on inflationary expectations. II. Summary
and Conclusions
The positive correlation between announced money supply innovations and changes in interest rates can be explained in two ways. Either the announcement of a jump in the money stock leads to an increase in the expected rate of inflation or it leads to an increase in the real rate because of expected future tightening by the Fed. In this paper foreign exchange market data was used to test the competing hypotheses. The expected inflation view implies that announced money supply innovations will be positively correlated with changes in the price of foreign exchange, while the Keynesian model predicts a negative correlation. The findings support the Keynesian model. For all five currencies studied the estimated correlation was negative. In two cases the correlation was significant at the 5 per cent level and in two other cases it was significant at the 10 per cent level. Thus the results clearly imply that money supply announcements have a significant impact on the ex-ante real rate of interest. The problem with this conclusion is that it is inconsistent with recent studies by Dwyer and Mishkin, among others, which
BRADFORD
CORNELL
conclude that actual innovations in the money rate. If actual innovations do not affect announcements of innovations? In addition, model to explain why the entire term structure announcements. The net result is a puzzle. Domestic studies have little impact on the real rate, while the market leads to the opposite conclusion. The future research.
207
supply do not affect the ex-ante real the real rate, then why should it is difficult to use the Keynesian shifts in response to money supply indicate that monetary innovations behavior of the foreign exchange resolution of this problem awaits
Notes 1. After I had completed the research for this paper and was in the process of writing the manuscript, I received a paper from Charles Engel and Jeff Frankel (1982) which employs essentially the same approach. I have added a paragraph in the empirical section comparing my results with theirs. 2. Actually, purchasing power parity need not hold even when goods markets are perfect if relative prices are variable and consumers in different countries have different tastes. Thus the simple monetary theory of the balance of payments, which assumes purchasing power parity, is implicitly a one-good model. 3. Since Frankel’s model is carefully explained in his two articles, the details are omitted here. 4. This test was originally suggested to me by my thesis advisor, Ron McKinnon, almost 5 years ago. The Fed’s change in operating procedure, however, has made the test more interesting by increasing the correlation between money supply announcements and changes in interest rates.
References Box. G.E.P. AND G.M. JEVKINS, Time Series An&if, San Francisco: Holden-Day, 1973. CORNELL, B., ‘Money Supply Announcements and Interest Rates: Another View’, unpublished working paper, Graduate School of Management, UCLA, 1982. DORNBUSCH, R., ‘Expectations and Exchange Rate Dynamics’, 1. Pal. Econ., December 1976, 84: 1161-76. DWYER, G.P., ‘Is Variation of the Expected Real Interest Rate Unpredictable?‘,]. Monet. Econ., 1981, 8: 59-84. EDWARDS, S., ‘Floating Exchange Rates, Expectations and New Information’, unpublished working paper, Department of Economics, UCLA, 1981. ENGEL, C. AND J. FRANKEL, ‘Why AMoney Announcements Move Interest Rates: An Answer from the Foreign Exchange Market’, unpublished working paper, Berkeley: Department of Economics, University of California, 1982. FA~A, E.F., ‘Short-term Interest Rates as Predictors of Inflation’, Amer. Econ. Rev., June 1975, 65: 269-282. FAXA, E.F. AND M.R. GIBBONS, ‘Inflation, Real Returns and Capita1 Investment’, 1. Monet. Econ. (forthcoming). FRANKEL, J., ‘On the Mark: A Theory of Floating Exchange Rates Based on Real Interest Rate Differentials’, Amer. Econ. Reu., September 1979, 69: 610-622. FRANKEL, J., ‘Monetary and Portfolio-Balance Models of Exchange Rate Determination’, unpublished working paper, National Bureau of Economic Research, No. 80-7, 1980. FREXK~L, J.A., ‘A Monetary Approach to the Exchange Rate: Doctrinal Aspects and Empirical Evidence’, Scand. f. Econ., February 1976, 8: 200-224. FREVKEL, J.A., ‘Flexible Exchange Rates, Prices and the Role of “News”: Lessons from the 197Os’, 1. Pal. Econ., August 1981, 89: 665-705. GARBADE, K. AND P. WACHTEL. ‘Time Variation in the Relationship Between Inflation and Interest’, 1. Monet. Econ., November 1978, 4: 755-765. GROSSMAN, J.. ‘The Rationality of LMoney Supply Expectations and the Short-run Response of Interest Rates To LMonetary Surprises’,;l. Monv, CreditandBan&g, November 1981,13: 409-24. HESS, P,J. AND J.L. BICKSLER. ‘Capital,Asset Prices versus Time Series rModels as Predictors of
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Monet Supp~ Announcements, Interest Rater, and Foreign Exchange
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