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What explains the stock market's reaction to Federal Reserve policy?

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  • Ben S. Bernanke
  • Kenneth N. Kuttner

Abstract

This paper analyzes the impact of unanticipated changes in the federal funds rate target on equity prices, with the aim of both estimating the size of the typical reaction and understanding the reasons for the market's response. We find that over the June 1989-December 2002 sample period, a typical unanticipated rate cut of 25 basis points is associated with an increase of roughly 1 percent in the level of stock prices, as measured by the CRSP value-weighted index. There is some evidence of a stronger stock price response to changes in rates that are expected to be more permanent or that represent a reversal in the direction of rate changes. The estimated response of stock prices to fund rate surprises varies widely across industries, but in a manner consistent with the predictions of the standard capital asset pricing model. Applying the methods of Campbell (1991) and Campbell and Ammer (1993), we find that most of the effect of monetary policy on stock prices can be traced to its implications for forecasted equity risk premiums. Some effect can be traced to the implications of monetary policy surprises for forecasted dividends, but very little stems from the impact of policy on expectations of the real rate of interest.

Suggested Citation

  • Ben S. Bernanke & Kenneth N. Kuttner, 2003. "What explains the stock market's reaction to Federal Reserve policy?," Staff Reports 174, Federal Reserve Bank of New York.
  • Handle: RePEc:fip:fednsr:174
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    References listed on IDEAS

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    More about this item

    Keywords

    Monetary policy ; Stock market ; Stock - Prices ; Federal funds rate;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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