Monetary Policy Effects on Long-Term Rates and Stock Prices

Abstract

This paper explains the effects of monetary policy surprises on long-term interest rates and stock prices in terms of changes in expected inflation, real interest rate and dividend growth, and relates these effects to markets' perceptions of economic shocks and Fed's information set. We analyze stock and bond futures price co-movements and relate them to Treasury Inflation-Protected Securities (TIPS) data. The sign of long-term interest rate reactions is mostly driven by changes in expected inflation. The sign of stock price reactions is mostly driven by changes in expected dividend growth, but it is also sometimes determined by changes in expected real rates. The co-movements of long-term interest rates and stock prices are determined by the co-movements of expected inflation and dividend growth. The majority of Fed's interest rate surprises are expected to be followed by negative co-movements between and output. This can be due to relatively more frequent inflation or supply shocks together with Fed's private information. Most Fed's actions are perceived as reactions to economic shocks rather than true policy shocks.