Bernanke and - THE JOURNAL OF FINANCE VOL LX NO 3 JUNE 2005 What Explains the Stock Markets Reaction to Federal Reserve Policy BEN S BERNANKE and

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THE JOURNAL OF FINANCE VOL. LX, NO. 3 JUNE 2005 What Explains the Stock Market’s Reaction to Federal Reserve Policy? BEN S. BERNANKE and KENNETH N. KUTTNER ABSTRACT 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. T 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.
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This note was uploaded on 01/29/2012 for the course ECONOMICS 101 taught by Professor Tikk during the Spring '11 term at University of Toronto- Toronto.

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Bernanke and - THE JOURNAL OF FINANCE VOL LX NO 3 JUNE 2005 What Explains the Stock Markets Reaction to Federal Reserve Policy BEN S BERNANKE and

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