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

In a recent contribution, Gallmeyer and Holli eld (2008) propose a model with heterogeneous beliefs and short sale constraints. They are able to show some e¤ects of heterogeneous beliefs and of short sales constraints on equilibrium volatility at a xed point in time through extensive simulations. However, their constraints are imposed exogenously, while the rich dynamics obtained in this paper come from the endogenous solvency constraints and binding regimes which arise naturally from limited commitment | Federal Reserve Bank of New York Staff Reports What Explains the Stock Market s Reaction to Federal Reserve Policy Ben S. Bernanke Kenneth N. Kuttner Staff Report no. 174 October 2003 This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in the paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors. What Explains the Stock Market s Reaction to Federal Reserve Policy Ben S. Bernanke and Kenneth N. Kuttner Federal Reserve Bank of New York Staff Reports no. 174 October 2003 JEL classification E44 G12 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 .

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