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Why does the Fed move markets so much? A model of monetary policy and time-varying risk aversion

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  • Pflueger, Carolin
  • Rinaldi, Gianluca

Abstract

We show that endogenous variation in risk aversion over the business cycle can jointly explain financial market responses to high-frequency monetary policy shocks with standard asset pricing moments. We newly integrate a work-horse New Keynesian model with countercyclical risk aversion via habit formation preferences. In the model, a surprise increase in the policy rate lowers consumption relative to habit, raising risk aversion. Endogenously time-varying risk aversion in the model is crucial to explain the large fall in the stock market, the cross-section of industry returns, and the increase in long-term bond yields in response to a surprise policy rate increase.

Suggested Citation

  • Pflueger, Carolin & Rinaldi, Gianluca, 2022. "Why does the Fed move markets so much? A model of monetary policy and time-varying risk aversion," Journal of Financial Economics, Elsevier, vol. 146(1), pages 71-89.
    • Handle: RePEc:eee:jfinec:v:146:y:2022:i:1:p:71-89
    DOI: 10.1016/j.jfineco.2022.06.002
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    3. Alex Hsu & Indrajit Mitra & Linghang Zeng, 2023. "The Profitability Channel of Monetary Policy Transmission," FRB Atlanta Working Paper 2023-06, Federal Reserve Bank of Atlanta.
    4. Alex Hsu & Indrajit Mitra & Linghang Zeng, 2023. "The Profitability Channel of Monetary Policy Transmission," FRB Atlanta Working Paper 2023-06, Federal Reserve Bank of Atlanta.

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    More about this item

    Keywords

    FOMC announcement; stock return; bond yield; habit-formation preferences; New Keynesian;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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