Asymmetric Information, Stock Returns and Monetary Policy

There are numerous empirical and theoretical studies that show that stock returns are affected by implementations of monetary policy. But, as mentioned in Bernanke and Kuttner (2005), very few studies tackle the question of why the stock market reacts to monetary policy. Romer and Romer (2000) and Sims (2002) show empirically that the Fed has superior information about future inflation and output. This paper investigates the reasons of stock returns’ reaction to monetary policy in the context of asymmetric information and learning. The analysis examines whether asymmetric information between the Federal Reserve and the public influences this relation between stock returns and monetary policy. It also constructs a Kalman filter algorithm to analyze the information and learning dynamics between the Federal Reserve and a representative investor. The paper concludes that asymmetric information is one of the reasons for the influence of monetary policy on stock returns. Stock returns react to monetary policy because the latter indirectly reveals the Fed’s private information about future inflation and output. Investors revise their expectations after observing the Fed’s actions and this produces a change in stock returns. This analysis has several policy implications. The results of the paper suggest that the policymaker should take into account the effects of monetary policy on the expectations of the public.