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Why does the Fed move markets so much? A model of monetary policy and time-varying risk aversion

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  • Pflueger, Carolin
  • Rinaldi, Gianluca

Abstract

We show that endogenous variation in risk aversion over the business cycle can jointly explain financial market responses to high-frequency monetary policy shocks with standard asset pricing moments. We newly integrate a work-horse New Keynesian model with countercyclical risk aversion via habit formation preferences. In the model, a surprise increase in the policy rate lowers consumption relative to habit, raising risk aversion. Endogenously time-varying risk aversion in the model is crucial to explain the large fall in the stock market, the cross-section of industry returns, and the increase in long-term bond yields in response to a surprise policy rate increase.

Suggested Citation

  • Pflueger, Carolin & Rinaldi, Gianluca, 2022. "Why does the Fed move markets so much? A model of monetary policy and time-varying risk aversion," Journal of Financial Economics, Elsevier, vol. 146(1), pages 71-89.
    • Handle: RePEc:eee:jfinec:v:146:y:2022:i:1:p:71-89
    DOI: 10.1016/j.jfineco.2022.06.002
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    Cited by:

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    3. Massimo Guidolin & Erwin Hansen & Gabriel Cabrera, 2023. "Time-Varying Risk Aversion and International Stock Returns," BAFFI CAREFIN Working Papers 23203, BAFFI CAREFIN, Centre for Applied Research on International Markets Banking Finance and Regulation, Universita' Bocconi, Milano, Italy.
    4. Kenan Qiao & Haibin Xie, 2024. "Time‐varying risk preference and equity risk premium forecasting: The role of the disposition effect," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 43(7), pages 2659-2674, November.
    5. Alex Hsu & Indrajit Mitra & Yu Xu & Linghang Zeng, 2023. "The Fed Information Effect and Firm-Level Investment: Evidence and Theory," FRB Atlanta Working Paper 2023-6a, Federal Reserve Bank of Atlanta, revised Mar 2024.
    6. repec:fip:fedawp:97980 is not listed on IDEAS
    7. Stefan Nagel & Zhengyang Xu, 2024. "Movements in Yields, Not the Equity Premium: Bernanke-Kuttner Redux," CESifo Working Paper Series 11305, CESifo.

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    More about this item

    Keywords

    FOMC announcement; stock return; bond yield; habit-formation preferences; New Keynesian;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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