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

In: Business and Management

Submitted By mm94621
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What Explains the Stock Market’s Reaction to Federal Reserve Policy?
Ben S. Bernanke Kenneth N. Kuttner∗ February 7, 2003

Abstract This paper analyzes the impact of unanticipated changes in the Federal funds 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. On average over the May 1989 to December 2001 sample, a “typical” unanticipated 25 basis point rate cut has been associated with a 1.3 percent increase in the S&P 500 composite index. The estimated response varies considerably across industries, with the greatest sensitivity observed in cyclical industries like construction, and the smallest in mining and utilities. Very little of the market’s reaction can be attributed to policy’s effects on the real rate of interest or future dividends, however. Instead, most of the response of the current excess return on equities can be traced to policy’s impact on expected future excess returns. JEL codes: E44, G12.

1 Introduction
The reaction of the stock market to monetary policy is clearly a topic of intense interest both to market participants and policymakers. Those holding equities would obviously like to know how possible Federal Reserve actions might affect the value of their portfolios. Similarly, an estimate of the likely effect of policy on asset prices is an important ingredient in assessing the transmission of monetary policy through the “wealth effect.” The size of and of Governors of the Federal Reserve System and Princeton University (Bernanke) and Federal Reserve Bank of New York (Kuttner). Correspondence to Ken Kuttner, Federal Reserve Bank of New York, 33 Liberty Street, New York, NY 10045, e-mail kenneth.kuttner@ny.frb.org. Thanks to John Campbell for his advice, and to Peter Bondarenko for research assistance. The views expressed here are solely…...

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