The Federal Reserve, through its monetary policy, controls federal funds rate by making changes reserve balances available to the banking system. Thus change in monetary policy most directly influences day to day operations of banks. In a recent study Bernanke and Kuttner (2005) examine monetary policy effect on equity prices. They show that equity market reaction comes from the unanticipated component of the monetary policy action. Bernanke and Kuttner (2005) argue that policy makers try to modify economic behavior by affecting the asset prices.
Their arguments are consistent with the popular balance sheet channel of credit channel theories of monetary policy transmission mechanism. However, Bernanke and Kuttner (2005) do not examine how banks are effected by anticipated and unanticipated component of monetary policy stance. Another well established (Bernanke and Blinder, 1992, Kashyap and Stein, 2000) sub-channel of credit channel theories is bank lending channel. According to this view in presence of credit market imperfections banks are well situated to deal with certain types of borrowers, especially small firms, but firms in general who can not access credit market through stocks and bonds.
In this paper we do not intend to test bank lending channel because an earlier body of research have already examined and established the importance of this channel. Our goal is quite modest. We seek to understand how monetary policy action (both expected and surprise component) have an effect upon banks using Federal fund futures data to construct market based expectation of future direction of monetary policy.
Thus our paper complements and extends Bernanke and Kuttner (2005) research to enhance our understanding of credit channel theories in general and bank lending channel in particular. In addition, we present evidence supporting bank capital channel proposed by Heuvel (2001, 2002).