What Explains the Stock Market's Reaction to Federal Reserve Policy?
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What they found
Using Kuttner's surprise measure on FOMC decisions from 1989 to 2002, the authors found that an unexpected 25 basis point cut in the fed funds rate raised the broad stock market by about 1% on the day. Decomposing the response, they showed that very little of it came from changes in expected real interest rates or dividends; most came from a change in the equity risk premium, that is, unexpected easing made investors demand less compensation for holding stocks. The reaction was larger for cyclical and high-beta sectors.
What you can use
- A surprise Fed cut of 25 bp has historically been worth about a 1% one-day gain in stocks; a surprise hike, roughly the reverse.
- The stock reaction works through risk appetite, not through the mechanical effect of rates on discounting.
- Cyclical and high-beta stocks react most; defensive sectors least.
Caveats
Sample ends 2002 and excludes the zero-lower-bound era. The response to unconventional policy and forward guidance requires different measures.
Tags: macro, fed, equities, monetary-policy
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.