What Explains the Stock Market¡¯s Reaction
to Federal Reserve Policy?
BEN S. BERNANKE and KENNETH N. KUTTNER.
ABSTRACT
This paper analyzes the impact of changes in monetary policy on equity prices, with
the objectives of both measuring the average reaction of the stock market and 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 1% increase in broad stock indexes. Adapting a methodology due to Campbell
and Ammer, 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.
THE ULTIMATE OBJECTIVES OF MONETARY POLICY are expressed in terms of macroeconomic
variables such as output, employment, and inflation. However, the
influence of monetary policy instruments on these variables is at best indirect.
The most direct and immediate effects of monetary policy actions, such
as changes in the Federal funds rate, are on the financial markets; by affecting
asset prices and returns, policymakers try to modify economic behavior in
ways that will help to achieve their ultimate objectives. Understanding the
links between monetary policy and asset prices is thus crucially important for
understanding the policy transmission mechanism.
This paper is an empirical study of the relationship between monetary policy
and one of the most important financial markets, the market for equities.
According to the conventional wisdom, changes in monetary policy are transmitted
through the stock market via changes in the values of private portfolios
(the ¡°wealth effect¡±), changes in the cost of capital ...