The reaction of stock returns to unexpected increases in the federal funds rate target

Abstract

This paper analyzes the impact of an unexpected increase in the federal funds rate target on stock returns. The main innovation is the use of a measure of monetary policy shocks based on the ACH-VAR (autoregressive conditional hazard VAR) model for the federal funds rate target. This model allows the analysis of two sources of an unexpected increase in the Fed target. This unexpected increase in the Fed target can be due to an unexpected increase in the federal funds rate target when it is expected to remain constant, or it can be due to an expected decrease in the federal funds rate target that fails to occur. These two events in the ACH-VAR model give rise to completely different information on the expected future federal funds rate. We examine the responses of stock returns for both S&P 500 stock returns and stock returns of portfolio sizes. We find that stock returns are more responsive to unanticipated increases in the federal funds rate than they are to unrealized expectations of a decrease in the federal funds rate. Our results also indicate that the firms with larger capitalization respond less to the two unanticipated monetary policy shocks.