The Response of Market Interest Rates to Discount Rate Changes

Article excerpt

IT IS WELL-ESTABLISHED that discount rate changes of the same size can have markedly different effects on market interest rates. Studies of such effects, starting with Thornton (1982), have generally divided discount rate changes into two groups: "technical" changes, those made solely to keep the discount rate in line with market rates, and other "non-technical" changes.(1) The former generally do not have a significant impact on market rates, while the latter generally do. The use of this technical/non-technical dichotomy is predicated on the assumption that the market responds to a discount rate change based on the reasons for the change. Hakkio and Pearce (1992) find that the reasons generally fall into three categories: "(1) conditions in the market for bank reserves ...; (2) movements in intermediate targets such as the money supply and the foreign exchange value of the dollar; and (3) movements in ultimate targets such as inflation and economic growth." They observe that "changes in the rate because of type (1) factors are likely to be used to complement open market operations, while changes because of type (2) or (3) factors are more likely to be used as signals of future Fed policy."(2) Thus, technical changes result when the opportunity cost to banks of borrowing reserves--the federal funds rate less the discount rate--is too high or low to be consistent with attaining the Fed's operating target. Since October 1982 that target has been the level of borrowed reserves.(3) Non-technical changes, on the other hand, encompass all of the other reasons the Fed might change the discount rate. Clearly a combination of the factors identified by Hakkio and Pearce can be behind a given discount rate change, so the reaction of market interest rates to discount rate changes might be more heterogeneous than the technical/non-technical dichotomy would suggest. Moreover, as the efficient markets hypothesis implies, the response of market interest rates to a discount rate change should vary with the amount of new information the discount change imparts regarding the Fed's policy intentions or the state of the economy in general.(4)

This article presents results on the differential response of market interest rates to discount rate changes using an econometric framework that explains more heterogeneous responses in market interest rates than the technical/non-technical dichotomy allows. The mixture model employed here assumes that the market response is determined by either a "high-response" or "low-response" data-generating process. Inferences about which process governs a given period's interest rate depend on the information policymakers cite when they change the discount rate. Thus, we can consider hypotheses like "the higher the unemployment rate, the larger the response of market interest rates to a discount rate change of a given size." With the technical/non-technical dichotomy, in contrast, a discount rate change is described as non-technical if the Fed mentions any number of things in its announcement, such as the inflation rate, unemployment rate, industrial production, money growth rate, etc. The technical/non-technical dichotomy tells us little about the relative importance of these individual factors. A principal aim of the mixture model employed here is to study the influence these individual factors have on the market response.

This paper also includes some conjectural interpretations of the empirical results. For example, if the market rates respond strongly to discount rate changes when the unemployment rate is high, one might conclude that the market believes that the Fed will consistently change monetary policy in reaction to shifts in the unemployment rate. Objectively, however, the mixture model's fit and forecasts of the interest rate response serve as measures of its performance relative to the standard technical/non-technical dichotomy. The second half of the paper addresses the implication of the efficient markets hypothesis that a discount rate change must be "news" for market rates to respond by testing whether the timing of discount rate changes is sufficiently predictable to require that models of the market's response to discount rate changes distinguish explicitly between anticipated and unanticipated changes. …