THE JOURNAL OF FINANCE
VOL. LX, NO. 3
What Explains the Stock Market’s Reaction
to Federal Reserve Policy?
BEN S. BERNANKE and KENNETH N. KUTTNER
This paper analyzes the impact of changes in monetary policy on equity prices, with
the objectives of both measuring the average reaction of the stock market and under-
standing the economic sources of that reaction. We find that, on average, a hypothetical
unanticipated 25-basis-point cut in the Federal funds rate target is associated with
about a 1% increase in broad stock indexes. Adapting a methodology due to Camp-
bell and Ammer, we find that the effects of unanticipated monetary policy actions on
expected excess returns account for the largest part of the response of stock prices.
HE ULTIMATE OBJECTIVES OF MONETARY POLICY
are expressed in terms of macroe-
conomic variables such as output, employment, and inflation. However, the
influence of monetary policy instruments on these variables is at best indi-
rect. The most direct and immediate effects of monetary policy actions, such
as changes in the Federal funds rate, are on the financial markets; by affect-
ing asset prices and returns, policymakers try to modify economic behavior in
ways that will help to achieve their ultimate objectives. Understanding the
links between monetary policy and asset prices is thus crucially important for
understanding the policy transmission mechanism.
This paper is an empirical study of the relationship between monetary pol-
icy and one of the most important financial markets, the market for equities.
According to the conventional wisdom, changes in monetary policy are trans-
mitted through the stock market via changes in the values of private portfolios
(the “wealth effect”), changes in the cost of capital, and by other mechanisms
as well. Some observers also view the stock market as an independent source of
macroeconomic volatility, to which policymakers may wish to respond. For these
reasons, it will be useful to obtain quantitative estimates of the links between
monetary policy changes and stock prices. In this paper we have two principal
objectives. First, we measure and analyze in some detail the stock market’s
response to monetary policy actions, both in the aggregate and at the level of
Board of Governors of the Federal Reserve System and Princeton University (Bernanke) and
Oberlin College (Kuttner). Thanks to John Campbell for his advice; to Jon Faust, Refet G¨urkaynak,
Martin Lettau, Sydney Ludvigson, Athanasios Orphanides, Glenn Rudebusch, Brian Sack, Chris
Sims, Eric Swanson, an anonymous referee, and the associate editor of this journal for their com-
ments; and to Peter Bondarenko for research assistance. The views expressed here are solely those
of the authors and not necessarily those of the Federal Reserve System.