The effects of economic news on Norwegian market interest rates.

Interest rates and other financial asset prices are based on expectations about economic developments. Asset prices react to new information. In this article, we explore the effects of news about key macroeconomic variables, external impulses, Norges Bank's interest rate decisions and the communication of monetary policy on Norwegian interest rates.

1 Introduction

An overview of the days with the largest movements in markets rates since the beginning of 2001 shows that interest rates react strongly to certain news or surprises (see Table 1). These "large" changes, which all occurred in the period up to February 2004, reflected either surprising interest rate decisions, monetary policy signals in speeches or at monetary policy meetings, surprising CPI figures or in a few cases international interest rate movements. None of the observations on the list is from the past three years. Have market participants been exposed to fewer surprises over the past three years, or do they react less to surprising macroindicators or monetary policy signals than earlier? It is relevant to investigate this in the light of the changes in monetary policy frameworks in Norway and internationally through the period.

The monetary policy objective of most central banks is price stability. Monetary policy operates with a lag, i.e. it takes time for changes in official policy rates to influence real economic variables and prices, and central banks' interest-rate setting will therefore reflect the outlook for output, employment and inflation. Information about the current situation in the economy is an important source of information when assessing future prospects. Central banks and market participants follow current developments in macroindicators. If they contain new information about the outlook, this affects interest rate expectations. A number of international studies confirm that key figure releases influence interest rate expectations. US key figures have a particularly strong impact on US interest rate expectations, but also on interest rate expectations in other countries.

Market participants do not fully understand how central banks assess the economic situation or how they will react to new information. Market interest rate expectations are thus also influenced by actual interest rate decisions and by central banks' communication of the monetary policy strategy ahead. The monetary policy framework in Norway and many other countries has changed considerably. A common feature is the shift to greater monetary policy transparency. Mervyn King, Governor of the Bank of England, has described this as a development where "mystery and mystique have given way to transparency and openness". With greater openness about monetary policy the degree of asymmetric information between central banks and the public has been reduced. Monetary policy has become more predictable, which has reduced the uncertainty about future interest rate developments. In tandem with the emphasis on transparency, there has been an international tendency towards a more gradualist approach to interest rate setting (2), perhaps best illustrated by the Federal Reserve's rate hikes from June 2004 in 17 increments of 0.25 percentage point. These changes have contributed to reducing the volatility of short-term interest rates and market participants have been less surprised by central banks' interest rate decisions than earlier.

We examine how Norwegian interest rate expectations, as measured by implied forward rates, react to macroeconomic news and monetary policy decisions, and whether these relationships have changed as a result of the shift to greater transparency in the conduct of monetary policymaking. The analysis is based on data that we have collected about news and market reactions, an overview that includes the most relevant news since the beginning of 2001.

Section 2 provides a review of the relevant literature in the field. Our selection of data and modelling strategy is explained in section 3, while the findings are discussed in section 4. Section 5 concludes.