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What Explains the Stock Market's Reaction to Federal Reserve Policy?

  • Ben S. Bernanke
  • Kenneth N. Kuttner

This paper analyzes the impact of changes in monetary policy on equity prices, with the objectives both of measuring the average reaction of the stock market and also of understanding the economic sources of that reaction. We find that, on average, a hypothetical unanticipated 25-basis-point cut in the federal funds rate target is associated with about a one percent increase in broad stock indexes. Adapting a methodology due to Campbell (1991) and Campbell and Ammer (1993), we find that the effects of unanticipated monetary policy actions on expected excess returns account for the largest part of the response of stock prices.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10402.

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Date of creation: Apr 2004
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Publication status: published as Bernanke, Ben S., and Kenneth N. Kuttner. "What Explains the Stock Market's Reaction to Federal Reserve Policy?" Journal of Finance 60(3): 1221-1257, June 2005
Handle: RePEc:nbr:nberwo:10402
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  1. Refet S. G├╝rkaynak & Brian P. Sack & Eric T. Swanson, 2006. "Market-based measures of monetary policy expectations," Working Paper Series 2006-04, Federal Reserve Bank of San Francisco.
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  3. Kuttner, Kenneth N., 2001. "Monetary policy surprises and interest rates: Evidence from the Fed funds futures market," Journal of Monetary Economics, Elsevier, vol. 47(3), pages 523-544, June.
  4. John Y. Campbell & Tuomo Vuolteenaho, 2002. "Bad Beta, Good Beta," Harvard Institute of Economic Research Working Papers 1971, Harvard - Institute of Economic Research.
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  7. Fama, Eugene F & French, Kenneth R, 1988. "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 246-73, April.
  8. John H. Cochrane & Monika Piazzesi, 2002. "The Fed and Interest Rates: A High-Frequency Identification," NBER Working Papers 8839, National Bureau of Economic Research, Inc.
  9. Thorbecke, Willem, 1997. " On Stock Market Returns and Monetary Policy," Journal of Finance, American Finance Association, vol. 52(2), pages 635-54, June.
  10. John Y. Campbell & John Ammer, 1991. "What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns," NBER Working Papers 3760, National Bureau of Economic Research, Inc.
  11. Faust Jon & Swanson Eric T & Wright Jonathan H, 2004. "Do Federal Reserve Policy Surprises Reveal Superior Information about the Economy?," The B.E. Journal of Macroeconomics, De Gruyter, vol. 4(1), pages 1-31, October.
  12. Ben S. Bernanke & Mark Gertler, 1999. "Monetary policy and asset price volatility," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pages 17-51.
  13. Goto, Shingo, 2000. "The Fed's Effect on Excess Returns and Inflation is Much Bigger Than You Think," University of California at Los Angeles, Anderson Graduate School of Management qt04f1z5hb, Anderson Graduate School of Management, UCLA.
  14. Faust, Jon & Swanson, Eric T. & Wright, Jonathan H., 2004. "Identifying VARS based on high frequency futures data," Journal of Monetary Economics, Elsevier, vol. 51(6), pages 1107-1131, September.
  15. William Poole & Robert H & Rasche & Daniel L. Thornton, 2002. "Market anticipations of monetary policy actions," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 65-94.
  16. d'Amico, Stefania & Mira Farka, 2003. "The Fed and Stock Market: A Proxy and Instrumental Variable Identification," Royal Economic Society Annual Conference 2003 52, Royal Economic Society.
  17. Ehrmann, Michael & Fratzscher, Marcel, 2004. "Taking stock: monetary policy transmission to equity markets," Working Paper Series 0354, European Central Bank.
  18. Campbell, John, 1991. "A Variance Decomposition for Stock Returns," Scholarly Articles 3207695, Harvard University Department of Economics.
  19. Glenn D. Rudebusch, 1995. "Federal Reserve interest rate targeting, rational expectations, and the term structure," Working Papers in Applied Economic Theory 95-02, Federal Reserve Bank of San Francisco.
  20. David H. Romer & Christina D. Romer, 2000. "Federal Reserve Information and the Behavior of Interest Rates," American Economic Review, American Economic Association, vol. 90(3), pages 429-457, June.
  21. John H. Boyd & Jian Hu & Ravi Jagannathan, 2005. "The Stock Market's Reaction to Unemployment News: Why Bad News Is Usually Good for Stocks," Journal of Finance, American Finance Association, vol. 60(2), pages 649-672, 04.
  22. Charles L. Evans & Kenneth N. Kuttner, 1998. "Can VAR's describe monetary policy?," Working Paper Series WP-98-19, Federal Reserve Bank of Chicago.
  23. Joel T. Krueger & Kenneth N. Kuttner, 1995. "The Fed funds futures rate as a predictor of Federal Reserve policy," Working Paper Series, Macroeconomic Issues 95-4, Federal Reserve Bank of Chicago.
  24. Brandt, Michael W. & Wang, Kevin Q., 2003. "Time-varying risk aversion and unexpected inflation," Journal of Monetary Economics, Elsevier, vol. 50(7), pages 1457-1498, October.
  25. Nelson, Charles R & Kim, Myung J, 1993. " Predictable Stock Returns: The Role of Small Sample Bias," Journal of Finance, American Finance Association, vol. 48(2), pages 641-61, June.
  26. Demiralp, Selva & Jorda, Oscar, 2004. "The Response of Term Rates to Fed Announcements," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(3), pages 387-405, June.
  27. Roberto Rigobon & Brian Sack, 2003. "Measuring The Reaction of Monetary Policy to the Stock Market," The Quarterly Journal of Economics, Oxford University Press, vol. 118(2), pages 639-669.
  28. Joel T. Krueger & Kenneth N. Kuttner, 1996. "The Fed funds futures rate as a predictor of federal reserve policy," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 16(8), pages 865-879, December.
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