The Interaction between financial markets and monetary policy

This thesis deals with the interaction between financial markets and monetary policy from three different perspectives. First, I study the perspective of equity investors and their reaction to the Federal Open Market Committee (FOMC) announcements, when they disagree on Nominal Interest Rate level decisions. My evidence shows that investor expectations formulated prior to FOMC announcements have a significant impact on equity prices, particularly when these expectations are not aligned with the FOMC committee decisions. My results reconcile past findings on the monetary policy surprise literature and more recent empirical findings on the effect of FOMC announcements on equity markets. Moreover, as I find no effect on equity returns when the FOMC committee decision is anticipated by the market, a practical implication of my study is that monetary policy authorities should take into account market expectations when formulating disclosure policy in order to improve alignment with financial market expectations and smooth out their economic consequences. \nSecond, I provide evidence of the effects of the European Central Bank (ECB) monetary policy shocks on the real economy, specifically on industrial production and inflation. This analysis investigates how the ECB monetary policy shocks impact industrial production (output) and inflation (prices) following the established narrative methodology of Romer & Romer (2004). Past standard statistical approaches have yielded very limited results in terms of magnitude. The narrative methodology, conversely, has yielded significant effects of monetary shocks on prices and output. Most of these studies analysed the effect of monetary policy in the United States and only a recent portion of the literature has extended the analysis to other countries (United Kingdom and Canada). This chapter contributes to the extant literature in extending the narrative methodology to the Eurozone and adapting it to include the unconventional monetary policies put in place by the Governing Council of the ECB in the past decade. To do so, I gather a novel dataset of macroeconomic forecasts and construct a new measure of monetary policy shocks. Industrial production responds to unpredictable monetary policy shocks with a decline of over 0.5%. On the contrary, inflation responds weakly to monetary shocks, with a very modest and unstable decrease of 0.05%. Furthermore, I provide empirical evidence of the heterogeneous responses of inflation and output among Eurozone countries. These last results are particularly relevant to policy makers of the ECB Governing Council, given that their policy decisions should have a homogenous effect on the Eurozone economy. \nThird, I investigate whether financial market stability is a concern for monetary policy makers in the case of the European Central Bank (ECB) and Bank of England (BOE). Whether financial market stability should be a concern of monetary policy makers is an unresolved and long debated question, which has resurfaced after the 2008 financial crisis. In this chapter, I propose a forward-looking Augmented Taylor (1993) Rule to investigate the conduct of monetary policy and apply this idea to the 2003–2018 time period for both the ECB and the BOE. I show that a forward-looking Augmented Taylor Rule explains the deviation of observed rates consistent with its implied rates. By including a measure of Financial Market Stability Slack, I also show that the evolving preferences of monetary policy makers have taken into account the financial markets turmoil, particularly in the aftermath of the 2008 financial crisis.

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