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Review of Financial Economics
journal homepage: www.elsevier.com/locate/rfe
What determines the stock market's reaction to monetary policy statements?☆ Alexander Kurov ⁎
College of Business and Economics, West Virginia University, Morgantown, WV 26506, USA
Received 5 October 2011
Received in revised form 30 May 2012
Accepted 26 June 2012
Available online 4 July 2012
We ﬁnd that information communicated through monetary policy statements has important business cycle dependent implications for stock prices. For example, during periods of economic expansion, stocks tend to respond negatively to announcements of higher rates ahead. In recessions, however, we ﬁnd a strong positive reaction of stocks to seemingly similar signals of future monetary tightening. We provide evidence that the state dependence in the stock market's response is explained by information about the expected equity premium and future corporate cash ﬂows contained in monetary policy statements. We also show state dependence in the average stock returns on days of scheduled FOMC meetings and in the impact of monetary policy statements on stock and bond return volatility.
© 2012 Elsevier Inc. All rights reserved.
At a media dinner in April 2006, the Fed Chairman Ben Bernanke told CNBC reporter Maria Bartiromo that investors underestimated his willingness to use monetary policy to ﬁght inﬂation. Immediately after Ms. Bartiromo reported it on her program, the S&P 500 index dropped by about 0.8% and Treasury bond yields jumped to four-year highs. Investors interpreted Mr. Bernanke's remark as a sign that the Fed may continue its interest-rate boosting campaign longer than previously thought. That casual remark became the biggest business news story of the day, if not the whole week.1 Speaking at a conference a few weeks later, the Fed Chairman reiterated his concern about inﬂation. The reaction of the stock market was summarized in a New York Times headline the following morning: “Bernanke Speaks, and Shares Tumble.”
☆ Partial funding for this research was provided by the Kennedy–Vanscoy Fund for Faculty Development in the College of Business and Economics, West Virginia University. I thank Rochelle Edge, Grigori Erenburg, Oleg Kucher, Dennis Lasser, Ming Liu, the seminar participants at the 2009 Meetings of the Financial Management Association and the 2012 Meetings of the Eastern Finance Association, and two anonymous referees for helpful comments and suggestions. Special thanks to Arabinda Basistha for many helpful discussions. Errors or omissions are my responsibility. ⁎ Tel.: +1 304 293 7892; fax: +1 304 293 3274.
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The Financial Times reported two days later: “Traders are calling it “The Bartiromo Affair.” Comments made by Ben Bernanke, Federal Reserve chairman, to a reporter at the weekend continued to reverberate yesterday after moving the markets on Monday.” (Hughes, 2006). 1058-3300/$ – see front matter © 2012 Elsevier Inc. All rights reserved. doi:10.1016/j.rfe.2012.06.010
Market participants analyze every word of Fed ofﬁcials for clues of possible directions of monetary policy because monetary policy affects asset prices, particularly stock prices. Monetary policymakers are also mindful of the effects of their words on ﬁnancial asset prices because monetary policy inﬂuences the real economy primarily through ﬁnancial markets, including the stock market. 2 Therefore, it is important for central bankers to understand what determines the market's reaction to their statements.
Most recent studies looking at the effect of monetary policy on the stock market (e.g., Bernanke & Kuttner, 2005; Ehrmann & Fratzscher,...