Money supply announcements and foreign exchange futures prices for five countries.

• Author: Sheehan, Richard G.

1. Introduction

   Since the Federal Reserve began targeting money supply growth in October 1979, the effects of Fed money supply announcements on financial markets have been intensively examined. Studies have considered the impacts on financial assets including yields on short-term and long-term Treasury securities, forward interest rates, exchange rates, stock prices, and commodity prices. These studies suggest that money supply announcements have had significant effects on all these financial assets. The effects, however, have not been consistent across time, assets, or countries.

   This study adds to the money supply announcement literature, focusing on foreign exchange spot and currency future prices. Mussa [23] provides a justification for this approach. He demonstrates that exchange rates move in accord with the efficient markets theory of asset price determination. In addition, he finds most exchange rate changes are unexpected. Thus, exchange rate changes generally should be related to "news" since unexpected changes must be due to new information. How exchange rates respond to news depends on how that information alters expectations. Those expectations, however, depend on economic agents' historical experience and on policymakers' anticipated reactions. Thus, the effects may vary across countries and across policymaking regimes.

   We believe this study makes four contributions to the money announcement literature. First, we develop a model of money announcements where expected announcements may be important even when markets are efficient. While we consider money announcements in particular, the model suggests a general result. Even expected announcements may affect financial market variables simply by confirming prior expectations. Second, we extend and update the prior literature by examining whether recent money supply announcements have an impact on exchange rates and whether recent impacts differ from those found through 1985. The results suggest the impact of money announcements may have diminished marginally. Third, we extend the analysis to exchange rate currency futures. Comparing the reactions of spot and futures rates yields further evidence on the "policy anticipation" versus the "expected inflation" effects. And fourth, most prior studies of unanticipated money growth do not distinguish between positive and negative surprises. If positive and negative surprises influence market prices asymmetrically, however, prior statistical tests may not correctly identify the response of financial markets to unanticipated money growth. Markets also may react differently to good news versus bad based on asymmetric loss functions. Thus, we test for asymmetry of money announcement effects. Recent studies by Cover [9], Sichel [29], and Beaudry and Koop [2] demonstrate the potential importance of macroeconomic asymmetry. The results below strongly suggest asymmetric response.

   Futures markets have received much attention in finance. In contrast, the linkages between futures prices and other markets have received little attention. The internationalization of world financial markets and the international coordination of monetary policy, however, suggests that the linkages between the money supply, expectations, and foreign exchange futures prices are a crucial concern to traders in foreign exchange markets and to foreign exchange operating sections of central banks. Thus, this study has important implications for monetary policy as well as for trading in foreign exchange markets. In particular, does the unanticipated component of money supply growth convey information about future exchange rates? Money growth larger than expected may cause expected appreciation of the dollar through interest rate channels. Alternately, unanticipated money growth could generate expected inflation leading to expected depreciation of the dollar.

   Section II discusses alternative hypotheses to explain the relationship between unexpected money shocks and financial asset prices. It also briefly reviews the related empirical literature. Section III states our theoretical model. Section IV discusses the data and empirical methodology employed. In Section V we present statistical results on the relationship between U.S. money surprises and currency future and spot prices for Canada, Japan, Germany, Switzerland, and the United Kingdom. Section VI offers a summary and some conclusions.

2. Alternative Hypotheses on the Effects of Unanticipated Money Announcements

   The widely documented positive correlation between interest rates and unexpected money growth is consistent with alternate interpretations. Unanticipated money growth may affect financial markets because of an expected reaction - or inaction - by the Federal Reserve. Alternately, markets may respond based on information inferred about future economic activity from the money surprise. Three hypotheses attempt to explain the effect of money supply announcements: the "expected inflation" hypothesis, the "policy anticipation" hypothesis, and the "real activity" hypothesis.(1)

   The expected inflation hypothesis assumes financial markets do not believe the Fed is committed to a given money growth policy. Simply stated, Fed policy is not credible. The Fed is expected to accommodate a positive monetary surprise, at least in part, by increasing money supply growth thus raising the inflation premium in nominal interest rates. Increased U.S. inflation relative to other countries also leads financial markets to expect the dollar to depreciate in both spot and futures markets.

   According to the policy anticipation hypothesis, market participants believe the Fed's attempt to offset a positive money surprise will raise some future real interest rates, assuming short-run price rigidity. Interest rates rise today anticipating their future increase. Market participants also expect an increase in the spread between U.S. and foreign real interest rates, leading to a capital inflow and an immediate appreciation of the U.S. dollar. Future real interest rates beyond some point, however, are not expected to change. Thus, exchange rate futures may increase for shorter contracts but remain unchanged for longer ones. The policy anticipation effect assumes Fed policy is credible. Market participants believe that faced with a demand shock the Fed will pursue monetary restraint to meet its policy objectives.

   The expected inflation and policy anticipation effects both predict that nominal interest rates will rise with unanticipated money growth. The expected inflation effect also predicts depreciation of the dollar with higher inflation while the policy anticipation effect predicts appreciation of the dollar due to increases in real interest rates.

   A third hypothesis, the real activity effect, is based on the information that monetary surprises contain about future output and money demand. If future output is a significant factor explaining variations in money demand, then unanticipated money growth may reflect an increase in money demand that indicates higher than expected future output. If the Fed does not accommodate increased money demand, real interest rates will rise. Thus, interest rates change based on the information that the announcement conveys about future output and money demand. This third hypothesis also implies the dollar appreciates with an unanticipated money increase. Increased expected real output will increase the demand for dollars, cause higher real interest rates, and lead to a capital inflow. Spot exchange rates and all futures rates should increase.

   An extensive empirical literature has examined these three hypotheses.(2) Prior studies generally have found that anticipated money growth announcements have little or no effect on capital market prices. Money surprises, however, have significant impacts on short-term and long-term interest rates. While the evidence has been mixed, most studies support the policy anticipation hypothesis. These studies also find that the impacts increased following the Federal Reserve's October 1979 change to a nonborrowed reserves operating procedure and decreased following the Fed's switch to a borrowed reserves procedure period in October 1982.(3) Most studies conclude that money surprises had a significant effect during the October 1979 - October 1982 period. Uncertainty remains on the economic and statistical significance of money surprises outside this interval.

3. Model

   The money announcement literature has focused on the response of financial variables over very short intervals. Our model considers a time interval short enough that a money announcement is made, efficient financial markets react to the announcement and no other information becomes available. We express the supply of foreign currencies algebraically as:

   [Mathematical Expression Omitted]

   where [e.sub.t] is the exchange rate, [I.sub.t] a vector of available information, and [X.sub.t] a vector of other factors influencing supply. Similarly, demand can be expressed as:

   [Mathematical Expression Omitted]

   where [Z.sub.t] is a vector of other factors influencing demand. To the above equations we add an equilibrium condition:

   [Mathematical Expression Omitted]

   that can be used to yield a reduced form expression for the exchange rate:

   [e.sub.t] = [f.sub.3]([I.sub.t], [X.sub.t], [Z.sub.t]). (4)

   We make three modifications to equation (4). First, since the variables included in X and Z change infrequently (like GDP) we exclude these vectors. Second, we decompose the information set into prior money growth, exchange rates and money announcements. We also include expectations of future money growth to incorporate a view on future monetary policy. And third, for analytical simplicity we assume the function is linear. Equation (4) becomes:

   [Mathematical Expression Omitted]

   where

   [M.sup.a] [is equivalent to] previously announced money stock (ignoring data revisions), and

   [Mathematical Expression...