What Explains the Stock Market’s Reaction to Federal Reserve Policy? Bernanke and Kuttner

Introduction Understanding the effect of monetary policy on stock prices is fundamental to understand the transmission mechanism of monetary policy through the wealth effect. The goal of the document is to identify how and why the stock market responds to monetary policy. To that end the authors analyze the effect of unexpected Fed funds rate changes, as proxied by the Fed funds future contracts, on various measures of stock market performance.

Measuring the surprise element of policy actions The “surprise” target rate change can be calculated as the change in the “spot month” Fed funds futures rate on the day of the rate change, scaled up by a factor related to the number of days in the month affected by the change. wherer u = unexpected target rate change f 0 s,t = spot-month futures rate on day t of month s m = number of days in the month affected by the change

From the previous expression, the expected component of the rate change is defined as: FED funds rate surprises are assumed to have occurred on the day after the FOMC’s decision. December 18 th is an exception. The authors recognize a possible problem with endogeneity.

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Regression Results The following equation is estimated: Where p t = the logarithm of the stock price The regression is estimated for the S&P500 composite, the CRSP value-weighted index, and for ten industry- specific indexes.

Principal results: 1. The market responds much more strongly to surprises than expected actions. 2. A surprise 25 basis point rate decrease leads to a 1.3 percent gain in the index. 3. The construction sector presents the largest coefficient. Mining and utility sectors the smallest.

Monthly estimates Evaluate the effect of monetary policy on the stock market at a monthly frequency. The measure of unanticipated policy actions is given by: wherer s,I = funds rate target day i of month s f 1 s-1,m = rate corresponding to the one-moth futures contract on the last mth day of months s-1.

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What explains the observed reaction of the stock market to monetary policy? Estimate the impact of Fed funds surprises on expected future dividends, real interest rates, and expected future excess returns. The authors find that the largest and only statistically significant effect is on the future excess return component.

The estimation is conducted using a VAR that includes the following variables: 1.Excess equity returns. 2.Real interest rate. 3.Relative bill rate (three-month bill rate minus its 12- month lagged moving average). 4.Dividend-Price ratio 5.Year-over-year CPI inflation.

Variance decomposition of equity returns The variance of the current excess return can be broken down into the sum of three variances: real interest rates, dividends, and expected future excess returns. The authors find that the variance in expected future excess returns accounts for the largest share of the variance of the current equity premium.

Conclusions For the overall S&P 500 composite index, an unexpected 25 basis point rate decrease is associated with a 1.3 percent increase in stock prices. Construction is the most responsive industry to monetary policy. The response of equity prices to monetary policy is not through effects on the real interest rate. The impact of monetary policy surprises on stock prices appears to come through its effects on expected future excess returns.