The cross-section of monetary policy announcement premium Hengjie Ai, Leyla Jianyu Han, Xuhui Pan and Lai Xu

Discussant: Annette Vissing-Jorgensen, University of California Berkeley

Empirical findings: Sort stocks based on average implied volatility reduction on scheduled FOMC, inflation, unemployment announcement days over past 8 months

• Portfolio 10-1: Excess return of 30 bps on scheduled FOMC announcement days (2.4%/year)

• Robust to controlling for CAPM beta: Not just a restatement of the known result that the CAPM does well on FOMC announcement days.

Model simulation findings:

• Calibrated long-run risk model can match these two facts if Fed news is news about the long-run risk component of consumption.

• Beta captures sensitivity to both long and short-run news. Since most news is short-run, a sort on beta is not a sort on long-run sensitivity.

Comment 1. Macro or monetary policy news?

Suggestion for better sorts and more macro announcements

Current paper: Does not distinguish between macro and monetary policy news.

• “We use the average of implied volatility reduction around all macroeconomic announcements (including inflation, unemployment and FOMC) during the past eight months”

• It is assumed that FOMC news is just one example of important macro news. Monetary policy news is unimportant. The Fed is letting out macro news.

I think authors can quite easily do more to tests to see if they have the right story.

Suggestion 1. Try not using past FOMC days in the sort

Suggestion 2. Calculate separate sensitivities (implied vol reductions) to macro news and FOMC news

If instead there are lots of firms with low macro news sensitivity but high FOMC announcement sensitivity and these have high FOMC ann. returns, then the story doesn’t hold up.

If you are correct that the Fed is irrelevant, just better informed:

• Main result should hold up even if you drop past FOMC days when sorting! Stocks with high macro sensitivity should do well on FOMC days because the Fed lets out macro news and macro news has a risk premium.

If you are correct that the Fed is irrelevant, just better informed:

• Macro news sensitivity and FOMC announcement sensitivity should be highly correlated in the cross-section of firms since FOMC news is macro news.

Instead, in that case:

• Monetary policy is crucial and has a risk premium, or • Monetary policy is crucial and has no risk premium, but policy surprises just

happened to be autocorrelated over this particular sample period (did you expect to be at the zero lower bound for 10 years???)

Keep in mind though: Highly correlated macro and FOMC sensitivities is a necessary but not sufficient condition for FOMC news being macro news

• If monetary policy news affects the same types of firms as does aggregate demand shocks, TFP shocks etc. we could find correlated sensitivities even if Fed news is monetary policy news.

Suggestion 3: Use more macro announcements

You can add power to the sort by using more macro announcements

• Maybe you already are – Ai and Bansal are. The paper is not clear on this. • Bloomberg has macro announcements on most days (21,160 announcements for

1996-2016 in data set from Cieslak and Vissing-Jorgensen (2019)) • Focusing on short announcement windows (-5 minutes to +25 minutes) would

allow using a large set of top announcements

Approaches to pick most relevant macro announcements.

• Use market participants assessment of relevance: Bloomberg relevance measure is based number of subscribers who set up alerts to follow a given announcement.

• Or use predictive power assessment of relevance: Estimate which macro news announcements have more predictive power for (longer-run) consumption growth.

Market participants’ assessment of relevance:

Comment 2. This literature is getting a bit ahead of itself. We first need to agree on whether the 24-hour return is even due to news from the Fed at all!

Remember the Lucca and Moench (2015) result: Pre-FOMC drift

They argue that this is a puzzle:

• The return is before the announcement when volatility is low • Shows up even for very liquid stocks or stock futures for which you could plausibly

trade out before the announcement at low cost • Suggests you can earn a high return without taking any extra risk.

Current paper:

• Simply assumes that the pre-FOMC return is in fact due to news from the Fed • Proceeds to argue that the Fed news is about the long-run component of growth

and that this has a large risk premium.

So, do the authors agree that the Fed is leaking/using informal communications channels during the pre-FOMC period?

• This needs to be stated upfront. • This is not an alternative to a Fed-leak explanation. • It is an argument for what is being leaked.

I suspect they agree since the need for leaks to generate a risk premium is well recognized and discussed in Ai and Bansal (2018).

• But other recent papers are not clear about the need for leaks Hu, Pan, Wang and Zhu (2019) “Premium for Heightened Uncertainty: Solving the FOMC Puzzle”, presented at last NBER AP.

• Without leaks, there is no heightened uncertainty during the pre-FOMC period.

The logical steps of the monetary policy-stock market research agenda:

1. Is the pre-FOMC news is in fact news from the Fed? 2. If yes, is the Fed news about:

a. The macro economy b. Monetary policy

3. In either case, figure out whether the positive average pre-FOMC return is: a. A risk premium b. A result of unexpectedly good news on average over post-1994 period.

Let me try to move your prior towards:

1. Yes, news from the Fed 2. b, monetary policy news 3. b, unexpectedly goods news on avg over this period.

Comment 3. My take so far on the 3 steps of the research agenda

Q1. Is the pre-FOMC news is in fact news from the Fed? I think yes

• Pre-FOMC effect is part of an even-week pattern in stock returns over the FOMC cycle that according to many pieces of evidence is driven by news from the Fed. Cieslak, Morse and Vissing-Jorgensen (2019)

• The pre-FOMC period is not that special:

In general, when Fed presidents and governors interact, the stock market moves suggesting that Fed news does in fact does matter for markets even when there are no formal announcements/speeches etc.

Morse and Vissing-Jorgensen (2019)

CMVJ argue that high even-week returns are in fact driven by monetary policy news which over post-1994 period has been positive for the stock market on average and has reached markets via informal communications channels:

1. Changes to the Fed funds target (rare post-1994 but common before that) tend to take place in even weeks in FOMC cycle time

2. Even-week stock returns are higher following board meetings of the Board of

Governors (with even-week meetings more important likely due to Board having a full fresh set of policy recommendations from Reserve Banks)

3. Fed funds futures rates on average declined in even weeks

4. “Fed put” pattern: About half of even-week returns arise due to even-week mean-

reversion in stock market following market declines

5. High even-week returns are robust to controlling for macroeconomic news releases, corporate earnings announcements and reserve maintenance periods

6. No evidence that Fed information releases or speeches by Fed officials line up

systematically with even weeks. Provide some examples of leaks.

Governor-president interactions and stock returns

(Morse and Vissing-Jorgensen (2019))

Hypothesis: Informal communication results from interaction of policy makers. Each policy maker has incentive to affect market expectations using information acquired in interactions. (Game theory in Vissing-Jorgensen (2019).)

FOIA requests for calendars of Fed governors (incl. chair, vice chair):

• Calendars of Bernanke, Yellen, Powell, Fischer and Tarullo: 28,818 calendar items • February 2007 to December 2017 • No board dissent over this period. Focus on interactions between governors and

Federal Reserve Bank presidents.

1,460 calendar items are phone calls or meetings between a governor and one or several Federal Reserve Bank presidents (1,410 are one-on-one).

• D(FR Bank President item)=1 for days with one or more governor calendar items reflecting calls/meetings with a Federal Reserve Bank president.

• D(FOMC item)=1 for days (mainly day -1 and 0 in FOMC cycle) with one or more governor calendar items reflecting calls/meetings of the Federal Open Market Committee (FOMC) which consists of both governors and presidents.

• Both dummies capture governor-president interactions. D(Week 0,2,4,6)=1 on 1,342 days.

D(Week 0,2,4,6)*D(FR Bank President item)=1 on 312 days.

D(Week 0,2,4,6)*D(FOMC item)=1 on 167 days.

D(Week 0,2,4,6)*D(No FR Bank Pres item, No FOMC item)=1 on 936 days.

• Findings not driven by Fed releases or speeches on days of governor-president

interactions or by good news leading to calls/meetings being scheduled. • Does not reveal precisely how governors or presidents get information to

markets. Perhaps they each have staff is in charge of communications?

Q2. Macro or monetary policy news? I think monetary policy news

• I’ll quickly reca[ results from literature on the Fed information effect • Then argue that if monetary policy actually works, this literature does not imply that

the main news from the Fed is macro (as opposed to policy) news. • The main news from the Fed is instead policy news.

Key role for Fed promises affecting risk premia.

Campbell, Evans, Fisher and Justiniano (2012) for unemployment expectations:

“The counterintuitive signs of the estimates in table 3 require an explanation. The one we favor interprets the GSS forward guidance as Delphic:

• The public believes that the FOMC has information about macroeconomic fundamentals that the public does not, and that monetary policy surprises arise from this informational advantage.

• In that case the forecast revision following a positive policy rate innovation encompasses the revelation of unexpectedly strong macroeconomic fundamentals as well as the contractionary effects of the innovation itself.”

Similar result in Nakamura and Steinsson (2018) for output growth expectations:

But what if monetary policy actually works?

Then the policy news shock is messed up as an indicator of the policy change and the above findings could be fully consistent with Fed news being policy news.

Example:

Suppose the Taylor rule was like this:

State of economy in 1 year Bad Good Probability 0.50 0.50 Unemployment 8% 4% Fed funds target 2% 6% Expected Fed funds target: 4%

Then suppose the Fed says: If the economy gets worse, we will lower to 0%, not 2%.

• Without any effect on probability of bad and good state:

State of economy in 1 year Bad Good Probability 0.50 0.50 Unemployment 8% 4% Fed funds target 0% 6% Expected Fed funds target: 3%

• But if policy shock lowers probability of bad state:

State of economy in 1 year Bad Good Probability 0.33 0.67 Unemployment 8% 4% Fed funds target 0% 6% Expected Fed funds target: 4%

An accommodating policy shock may not move the expected Fed funds target down!

Is there a lot of this type of “tail risk forward guidance”?

Yes! That’s the Fed put from CMVJ: Following market drops, in weeks of Fed decision making, the market rebounded and risk premia fell (1994-2016)

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• Interpretation: The Fed gave guidance that it would accommodate if things got worse: “stand ready to act as needed” (Fed-speak for “whatever it takes”) – tail risk FG. This Fed put was stronger than markets expected over this period.

• No reduction in Fed funds futures on these days. To see this type of accommodation, you need to look at the stock market (which benefits from the reduced probability of the bad state).

To summarize: If, on FOMC announcement days, you see yields up and private sector forecasters getting more optimistic, this could mean either:

- The Fed is better informed about the economy and is tightening on good information. Monetary policy itself is irrelevant.

- The Fed is not better informed about the economy, but is promising accommodation if needed. Monetary policy is important.

Q3. Does the pre-FOMC effect a risk premium or due to unexpectedly good news on average over the post-1994 period? I think unexpectedly good news

We discussed the Fed put evidence and futures evidence from CMVJ.

Furthermore:

1. If it is a risk premium why is it also there in weeks 2, 4, 6? No one knew about the FOMC cycle before we documented it so how can it be a risk premium?

2. If it is a risk premium, why is it also there when governor and presidents interact? No one knew about the governor-president effect until we documented it so how can it be a risk premium?

3. (Weaker argument) If it is a risk premium, why it is not there for other central banks? Is the Fed that much more important than the ECB, BoE, BoJ? Seems more plausible that the Fed instead was unexpectedly accommodating.

4. If you ask top Fed watchers why the watch the Fed it’s because the Fed sets policy, not because they think the Fed is that much better at forecasting the economy.

Brusa, Savor and Wilson (2018): No risk premium on days of other CB announcements