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Fed (What Explains the Stock Market’s Reaction to Fed Policy)

Fed (What Explains the Stock Market’s Reaction to Fed Policy)

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What Explains the Stock Market’s Reaction to Federal Reserve Policy? Ben S. Bernanke Kenneth N. Kuttner March 2004 Abstract This paper analyzes the impact of changes in monetary policy on equity prices, with the objectives both of measuring the average reaction of the stock market and also of understanding the economic sources of that reaction. We fi nd that, on average, a hypothetical unanticipated 25-basis-point cut in the federal funds rate target is asso- ciated with about a one percent increase in broad stock indexes. Adapting a methodol- ogy due to Campbell (1991) and Campbell and Ammer (1993), we fi nd that the effects of unanticipated monetary policy actions on expected excess returns account for the largest part of the response of stock prices. JEL codes: E44, G12. Board of Governors of the Federal Reserve System and Princeton University (Bernanke) and Oberlin College and NBER (Kuttner). Correspondence to Ken Kuttner, Economics Department, Rice Hall, 10 North Professor Street, Oberlin, OH 44074, e-mail [email protected] 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 the Journal of Finance for their comments; 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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1 Introduction The ultimate objectives of monetary policy are expressed in terms of macroeconomic vari- ables such as output, employment, and in fl ation. However, the in fl uence of monetary policy instruments on these variables is at best indirect. The most direct and immediate effects of monetary policy actions, such as changes in the federal funds rate, are on the fi nancial mar- kets; by affecting 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 policy and one of the most important fi nancial markets, the market for equities. According to the con- ventional wisdom, changes in monetary policy are transmitted 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 industry portfolios. Sec- ond, we try to gain some insights into the reasons for the stock market’s response.
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