Federal Funds Rate Changes: A Test of Market Efficiency

This study tested the effect of two federal funds rate increase and two federal funds rate decrease announcements on stock price performance. Using standard risk adjusted event study methodology with the market model, the study analyzed 22,444 recent observations for the four event study periods from the thirty DOW firms with total market capitalization of three and one-half trillion dollars and the S&P 500 Index to examine the impact of the federal funds rate change announcements on stock price. Results show a significant negative market reaction prior to the announcements of both increases and decreases in the change in the federal funds rate. This suggests the market associates possible economic instability with any Federal Reserve intervention and views this discretionary monetary policy action as a negative signal. This is consistent with Milton Friedman’s monetarist theory stating that Keynesian discretionary monetary policy creates rather than corrects economic instability. Findings support efficient market theory at the semi-strong form level as documented by Fama (1970). Similar too many other event study findings in the finance literature (stock splits, repurchases, dividend announcements and etc.), effects of trading activity on the basis of the anticipated announcement surfaced prior to it being made public.