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Research Papers in Economics

FED RAL RESERVE BANK
OF SAN FRANCISCO
.....CONOMIC
R VIEVV
SPRING 1878Markets provide consumers and producers
with information-the prices at which they can
buy and sell-which they need to make rational
economic decisions. Economists judge market
performance both by the reliability of the infor-
mation conveyed and by the efficiency with
which market participants utilize that informa-
tion. The four articles in this issue examine ques-
tions of the quality of information and the
efficiencyofits use in various specific markets -
Treasury bills, GNMA futures, commodity mar-
kets and the stock market.
William Poole applies such an analysis to the
market for Treasury-bill futures which began
trading in early 1976. The evidence suggests that
the T-bill futures market is closely linked to the
spot market in bills, at least for the nearest fu-
tures maturity. Unexploited arbitrage opportuni-
ties between the two markets rarely exist.
In Poole's view, the existence of the explicit in-
terest-rate forecasts provided by the futures mar-
ket emphasizes the need for policymakers to
understand why discrepancies arise between
market forecasts and their own interest-rate
forecasts. "If, at some point in time, rates in the
bill futures market are based on forecasts of a
strong and/or more inflationary economy than
projected by policymakers, and if the market is
correct, then there is a danger that policymakers
will determine a more expansionary policy than
is appropriate for the needs of the economy."
Market interest-rate forecasts also may reflect
forecasts of policies that are different from those
that policymakers are actually planning. Conse-
quently, policymakers should make their plans
known and ensure that announced policy plans
are realized. However, this raises the question of
how adjustments may be made in response to
changing economic conditions. Poole sees no easy
solution to this dilemma, except perhaps by in-
5
eluding in the concept of a policy plan an under-
standing of the policy adjustments required by
certain contingencies.
Poole notes that today's futures rate is not an
especially accurate forecast of"tomorrow's" spot
rate, so that its policy significance ought not to
be exaggerated. However, policymakers' own
forecasts of interest rates are not very accurate
either. "Unless policymakers have solid evidence
that their own forecasts are more accurate than
market forecasts, they cannot afford to ignore
the T-bill futures market."
Kenneth Froewiss analyzes another new type
of market the futures market in the financial
instruments of the Government National Mort-
gage Association (GNMA). This market was in-
augurated in late 1975 by the Chicago Board of
Trade, but it is the result of several earlier devel-
opments dating back to the late 1960's. The first
was the mortgage industry's attempt to devise a
hedging mechanism to protect itselffrom unfore-
seen interest-rate fluctuations. The second was
GNMA's introduction of a new - the
pass-through certificate- to attract more inves-
tors to the housing market.
Froewiss' empirical results suggest that the
GNMA spot market has its
mance in the period since futures began
in those securities. "The spot market has become
more efficient in processing new information; it
has shown less purely random variability;
and it has become more closely integrated with
the rest of the bond market. Futures trading is
not necessarily responsible for any ofthose bene-
ficial developments, but it has not had a
destabilizing effect on prices of
GNMA certificates.
Froewiss argues that these conclusions have a
wider reference than to the GNMA market
alone. Financial futures markets are still in theirinfancy, so that more and more ofthem are likely
to be established. "The results of this study of
GNMA futures suggest that we have nothing to
fear and potentially much to gain from the fur-
ther development of these markets."
Michael Gorham, in a third paper, discusses
the development of information in commodity
markets. Most market participants rely upon
some source orsources ofinformation to enhance
their decision-making abilities, obtaining this in-
formation from both the public and private sec-
tors. Gorham explores the relationship between
public- and private-market information, with
particular emphasis on a specific market with a
large component of public-sector information -
the market for agricultural commodities.
Gorham shows how public information both
destroys and creates opportunities for providers
of private-sector information. He then measures
the private sector's response to these new oppor-
tunities in the case of three major agricultural
commodities with highly-developed spot and fu-
tures markets. His analysis indicates that pri-
vate-information sources correctly forecast
public-sector announcements for soybeans, but
not for corn and wheat.
For technical reasons, the quality ofboth types
of information generally improves during each
individual crop year. However, over longer per-
iods, public-sector information has improved in
quality, whereas the private sector's forecasting
ability has lagged behind. Gorham does not find
this surprising. "The public sector, unlike the pri-
vate sector, is not constrained by considerations
ofprofitability when adopting improved methods
of forecasting or expanding its survey activities
although ofcourse it is subject to certain bud-
get constraints." The U.S. Department of Agri-
culture thus has been better situated than the
private sector to improve its forecasting ability.
Kurt Dew, in a final paper, considers the infor-
mation provided by the stock market as a means
6
of analyzing changes in monetary-policy behav-
ior. He poses the question - "Are changes in
policy procedures only differences in style or
does monetary policy now affect the economy in
a substantially different way than it did in the
1960's?" Utilizing the theory of efficient mar-
kets, he answers by saying that the Federal Re-
serve's response to money growth has changed,
and as a result, the economic impact of a tempo-
rary deviation of money growth from trend has
actually been reversed.
Dew makes the case that the Fed today raises
interest rates in response to undesirably rapid
money growth, whereas it did not do so in the
1960's. This change in response is revealed indi-
rectly, through an analysis of the stock market's
response to the money supply. He points to evi-
dence that the stock market today (unlike the
1960's) responds negatively to an increase in the
money supply. He then bolsters his conclusion
with the proposition that the stock market is an
efficient forecaster of the future economic im-
pact ofa change in the money supply, which im-
pact in turn depends on the Federal Reserve's
policy reaction.
Dew argues that the new emphasis on the mon-
etary aggregates has in fact altered the structure
ofthe economy, and that most econometric mod-
els ofthe monetary-transmission process are mis-
specified as a result. Hequestions the naive inter-
pretation of the portfolio-adjustment theory
namely, that an excess demand or supply ofmon-
ey precedes changes in long-term interest rates
and equity values, which changes in turn influ-
ence levels of real economic activity. Dew's em-
pirical work instead indicates that stock prices
and interest rates primarily reflect anticipated
trend rates ofmoney growth. "Thus, according to
a more accurate interpretation of portfolio the-
ory, past rates of money growth affect current
real economic activity only if they affect fore-
casts of future money growth."

Information and market efficiency

http://www.frbsf.org/publications/economics/review/1978/78-2_5-6.pdf

Information and market efficiency

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