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The market's reaction to discount changes: what's behind the announcement effect?

Listed author(s):
  • Daniel L. Thornton

Market interest rates respond to discount rate changes. What is the reason for this response. This paper investigates several competing hypotheses of why markets respond to discount rate changes. Evidence that the response is invariant to changes in the Federal Reserve's operating procedure suggests that it is purely an "announcement effect." Contrary to common belief the evidence suggests that the does not depend critically on whether the discount rate change is unanticipated, because all discount rate changes appear to be largely unanticipated. Additional evidence suggests that, despite the fact that there have been instances when discount rate was used to signal a change in policy, e.g., the one percentage point increase in the discount rate in October 1979, generally speaking, discount rate changes do not appear to have "signaled" a change in monetary policy. This suggests that the common assertion that market interpret discount rate changes as a signal of a change in Fed policy is incorrect. It appears that changes expectations about monetary policy is not the only reason--and perhaps not the most important reason--for the market's reaction to changes in the discount rate.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 1992-003.

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Date of creation: 1992
Handle: RePEc:fip:fedlwp:1992-003
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  1. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, vol. 48(4), pages 817-838, May.
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