Monetary-Policy Risk and Equilibrium Asset Prices

We quantify the effects of uncertainty about the conduct of monetary policy on asset prices. Nominal yields, real yields, stock returns, and implied volatilities all vary more on days with FOMC communication than on FOMC “blackout” days, consistent with policy communication being a source of risk. Furthermore, these asset prices all respond significantly to changes in interest-rate uncertainty around FOMC announcements, consistent with that risk being priced. A New Keynesian model with stochastic variation in the policy rule quantitatively matches this evidence. Our model shows that monetary-policy risk contributes to excess returns on equities and nominal bonds and accounts for much of the risk premium on inflation-indexed bonds. Transitory increases in monetary-policy risk lower stock and bond prices, reduce inflation-risk premia, and generate macroeconomic weakness similar to that produced by aggregate-demand shocks. The effective lower bound on interest rates reduces the size of monetary-policy risk in the model but magnifies its asset-pricing consequences, consistent with the data. We use our model to assess the effects of the increase in monetary-policy risk that occurred following the rapid tightening of policy in 2022.