Free Markets to Fed Markets: How Modern Monetary Policy Impacts Equity Markets

Abstract

The US Federal Reserve doubled its balance sheet during the COVID-19 pandemic in the most aggressive unconventional monetary policy on record. I show that the scale and scope of these actions substantially impacted stock markets, explaining at least one-third of their rebound. The impact occurs predominantly through bond yields (discount rates) and expectations of future macroeconomic conditions (future cash flows). I find while the Fed’s balance sheet expansions are more rapid than its contractions, the stock market is more sensitive to contractions. The findings have implications for possible impacts of central banks unwinding the positions accumulated during the pandemic.