Monetary policy uncertainty and stock market returns: influence of limits to arbitrage and the economic cycle

Abstract

PurposeThis paper aims to examine the impact that monetary policy uncertainty (MPU) has on stock market returns by taking into account limits to arbitrage and the economic cycle.Design/methodology/approachUsing four news-based MPU measures, regression models have been applied in this study over a sample period from January 1985 to March 2020. The limits to arbitrage have been considered by taking Russell 1000 Value, Russell 1000 Growth, Russell 2000 Value and Russell 2000 Growth indices, and business cycles were established following the National Bureau of Economic Research.FindingsA negative MPU impact on stock returns has been found. In particular, the most subjective and difficult to arbitrate stocks have been more sensitive to MPU. However, it could not be concluded that MPU has a greater or lesser impact on stock returns depending on the economic cycle.Practical implicationsThe findings obtained are particularly useful for monetary policymakers showing the importance and need for greater control over the transparency of their decisions to maintain the stability of financial markets. The findings obtained are also useful for investors when selecting their investment assets at times of the highest MPU.Originality/valueTo the best of the authors’ knowledge, this is one of the few studies investigating the effect of MPU on stock market returns, and the first to analyse this relationship taking into account the economic cycle and limits to arbitrage.