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Stock market reaction to fed funds rate surprises: State dependence and the financial crisis

  • Kontonikas, Alexandros
  • MacDonald, Ronald
  • Saggu, Aman

This paper examines the response of US stock returns to Federal Funds rate (FFR) surprises between 1989 and 2012, focusing on the impact of the recent financial crisis. We find that outside the crisis period, stock prices increased as a response to unexpected FFR cuts. State dependence is identified with stocks exhibiting larger increases when interest rate easing coincided with recessions, bear markets, and tightening credit conditions. However, an important structural shift occurred during the crisis, changing the stocks’ response to FFR shocks and the nature of state dependence. Throughout the crisis period, stocks did not react positively to unexpected FFR cuts, which were interpreted as signals of worsening future economic conditions. This triggered a rebalancing of investment portfolios away from falling equities and towards safe-haven assets. Our results highlight the severity of the crisis and the ineffectiveness of conventional monetary policy close to the zero lower bound.

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Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 37 (2013)
Issue (Month): 11 ()
Pages: 4025-4037

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Handle: RePEc:eee:jbfina:v:37:y:2013:i:11:p:4025-4037
DOI: 10.1016/j.jbankfin.2013.06.010
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