Federal Reserve Reaction Research Articles

When does the fed care about stock prices?

We propose a novel identification approach based on a predictable change in the intraday volatility of index futures to estimate the Federal Reserve's reaction to stock returns. This identification approach relies on a weaker set of assumptions than required under identification through heteroskedasticity based on lower frequency data. Our approach also allows the examination of changes in the reaction of monetary policy to the stock market. We document an asymmetric response of policy expectations to changes in stock prices in adverse and positive economic environments. Specifically, the results show a sharp increase in the response of monetary policy expectations to stock returns during recessions and bear markets. This finding is consistent with the existence of the so-called “Fed put.”

The Calming of Short-Term Market Fears and Its Long-Term Consequences: The Federal Reserve's Reaction to COVID-19

We study the impact of five key Fed policy responses to the Covid-19 crisis on the stock market's fear of loss and fear of variability. Using a unique global dataset of option prices to construct the term structures of fear, up to ten years into the future, we find that FX swap lines have the most decisive impact on market fear, but only on the US and countries with access to the swaps. Liquidity support and macroprudential policies had a smaller but still significant impact, while policies aimed to support the wider economy did not affect fear. These results raise important questions on the trade-off between short-term market calming and long-term moral hazard, as well as the relative importance of central banks, and the importance of the Federal Reserve as a global liquidity provider.

Mapping the Federal Reserve's Reaction Function with Directed Acyclic Graphs

Under the monetary policy framework introduced by Benjamin Bernanke during the 2008 financial crisis, the value of currency in circulation as a proportion of the value of the assets side of the balance sheet has become a choice variable for implementing policy. Before 2008 changes in this variable appear to be incidental, thus providing a natural experiment to evaluate the effects of changes before and after implementation of the new policy framework. While the response of policy to changing economic conditions is straightforward, the response of the macroeconomy to these policy changes needs clear elaboration. We employ directed acyclic graphs (DAGs) to evaluate the response of monetary policy to changing economic indicators. We are interested in mapping the effects of changes in the federal funds rate as well as the effects of changes in the value of assets held by the Federal Reserve. We evaluate the causal chains presented in each DAG by considering the relevant marginal effects as estimated by corresponding seemingly unrelated regressions and vector autoregressions.

Monetary Policy, Trend Inflation, and the Great Moderation: An Alternative Interpretation

With positive trend inflation, the Taylor principle does not guarantee a determinate equilibrium. We provide new theoretical results on determinacy in New Keynesian models with positive trend inflation and new empirical findings on the Federal Reserve's reaction function before and after the Volcker disinflation to find that, (i) while the Fed likely satisfied the Taylor principle before Volcker, the US economy was still subject to self-fulfilling fluctuations in the 1970s, (ii) the US economy switched to determinacy during the Volcker disinflation, and (iii) the switch reflected changes in the Fed's response to macroeconomic variables and the decline in trend inflation. (JEL E12, E23, E31, E32, E52)

Measuring The Reaction of Monetary Policy to the Stock Market

Movements in the stock market can have a significant impact on the macroeconomy and are therefore likely to be an important factor in the determination of monetary policy. However, little is known about the magnitude of the Federal Reserve's reaction to the stock market. One reason is that it is difficult to estimate the policy reaction because of the simultaneous response of equity prices to interest rate changes. This paper uses an identification technique based on the heteroskedasticity of stock market returns to identify the reaction of monetary policy to the stock market. The results indicate that monetary policy reacts significantly to stock market movements, with a 5% rise (fall) in the S&P 500 index increasing the likelihood of a 25 basis point tightening (easing) by about a half. This reaction is roughly of the magnitude that would be expected from estimates of the impact of stock market movements on aggregate demand. Thus, it appears that the Federal Reserve systematically responds to stock price movements only to the extent warranted by their impact on the macroeconomy.

Measuring the Reaction of Monetary Policy to the Stock Market

Movements in the stock market can have a significant impact on the macroeconomy and are therefore likely to be an important factor in the determination of monetary policy. However, little is known about the magnitude of the Federal Reserve's reaction to the stock market. One reason is that it is difficult to estimate the policy reaction because of the simultaneous response of equity prices to interest rate changes. This paper uses an identification technique based on the heteroskedasticity of stock market returns to identify the reaction of monetary policy to the stock market. The results indicate that monetary policy reacts significantly to stock market movements, with a 5% rise (fall) in the S&P 500 index increasing the likelihood of a 25 basis point tightening (easing) by about a half. This reaction is roughly of the magnitude that would be expected from estimates of the impact of stock market movements on aggregate demand. Thus, it appears that the Federal Reserve systematically responds to stock price movements only to the extent warranted by their impact on the macroeconomy.

Measuring the Reaction of Monetary Policy to the Stock Market

Movements in the stock market can have a significant impact on the macroeconomy and are therefore likely to be an important factor in the determination of monetary policy. However, little is known about the magnitude of the Federal Reserve's reaction to the stock market. One reason is that it is difficult to estimate the policy reaction because of the simultaneous response of equity prices to interest rate changes. This paper uses an identification technique based on the heteroskedasticity of stock market returns to identify the reaction of monetary policy to the stock market. The results indicate that monetary policy reacts significantly to stock market movements, with a 5% rise (fall) in the S&P; 500 index increasing the likelihood of a 25 basis point tightening (easing) by about a half. This reaction is roughly of the magnitude that would be expected from estimates of the impact of stock market movements on aggregate demand. Thus, it appears that the Federal Reserve systematically responds to stock price movements only to the extent warranted by their impact on the macroeconomy.

The Federal Reserve's reaction function under Greenspan: An ordinal probit analysis

An ordinal probit technique is employed on monthly data to explain discrete changes in the targeted Federal funds rate since August 1987. Changes in industrial production and precursors of final good inflation appear to have significant effects on the Federal Reserve's behavior, while consumer prices, unemployment, and other variables often thought to influence its actions do not. These results are robust to a variety of alternative specifications, including the use of greenbook forecasts and those derived from Taylor's Rule. The results suggest that the Federal Reserve seeks to stabilize output and preemptively control inflation before it reaches the consumer level.

Do Measures of Monetary Policy in a Var Make Sense?

No. In many vector autoregressions (VARs), monetary policy shocks are identified with the least squares residuals from a regression of the federal funds rate on an assortment of variables. Such regressions appear to be structurally fragile and are at odds with other evidence on the nature of the U.S. Federal Reserve's reaction function; furthermore, the residuals from these regressions show little correlation across various VARs or with funds rate shocks that are derived from forward-looking financial markets. My results provide a sharp critique of current monetary VARs.

The Federal Funds Rate and the Implementation of Monetary Policy: Estimating the Federal Reserve's Reaction Function

Several recent studies have reached quite different conclusions about which variable is the best indicator of the stance of monetary policy. These differences likely reflect varying assumptions about bank and Federal Reserve behavior. This paper takes a detailed and comprehensive look at the implementation of monetary policy and the identification of monetary policy shocks. The paper first outlines a general analytical model for studying and evaluating monetary policy procedures. The model is then used to estimate both the Fed's operational policy objectives and its intermediate objectives. The results can be summarized as follows: First, monetary policy shocks over the past several years have primarily affected the federal funds rate, even during periods when the Fed was reportedly targeting reserves. In addition, the paper finds a statistically-significant liquidity effect in all periods examined, although the effect is quite small. Finally, there is statistical evidence that suggests that the Fed's intermediate objectives have not been stable over time, and these differences appear to be economically important. Taken together, these results indicate that while monetary policy shocks can be uncovered by regressing the funds rate on appropriate variables in the Fed's information set, the reaction function should be estimated over subperiods rather than over the entire 1959-1993 period.

Money and the Lender of Last Resort

In 1957, when my Central Banking and Money Market Changes appeared, there may have been some novelty in pointing out that the monetary and financial instruments, usages, and behavior of the significant banking institutions and financial markets changeor evolvein response to perceived profit opportunities. In 1985, it is commonplace. But the acceptance of the fact that the substance of money has changed strikingly over the past four decades has not significantly changed the way monetary theorists think about money. The assumption of exogenous moneythat there is a well-defined, exogenously determined money supply that the central bank can control with adequate precisionstill permeates monetary theory. Banks still are viewed as passive reactors that transform high-powered money into public money; profit-maximizing behavior by business apparently does not extend to banks and bankers. Since the mid-1960s, the world's central banks, and our own Federal Reserve System, have been at least as concerned with maintaining the integrity of the banking and financial structure as with the control of a money supply in order to guide the economy to some desired performance goal. Beginning with the Federal Reserve's reaction to the credit crunch of 1966 and continuing through the recent episodes of domestic a d international financial trauma, the Federal Reserve has episodically tossed aside any pretense of trying to achieve economic stability through monetary control. It has concentrated its interventions on de-

Assessing the impact of varying economic conditions on federal reserve behavior

The purpose of this paper is to examine the nature of the response by the Federal Reserve to changes in economic conditions. Unlike previous studies, however, the specification of the reaction function for the Federal Reserve employed here will take account of the fact that the marginal response may vary with the severity of economic conditions. Whether or not this is the case is determined by developing a generalized spline estimator. It is found that the Federal Reserve's reaction to economic conditions does indeed vary with the severity of these conditions. The implications of this finding are discussed.