Academic journal article Review - Federal Reserve Bank of St. Louis

The Evolution of Federal Reserve Policy and the Impact of Monetary Policy Surprises on Asset Prices

Academic journal article Review - Federal Reserve Bank of St. Louis

The Evolution of Federal Reserve Policy and the Impact of Monetary Policy Surprises on Asset Prices

Article excerpt

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Since the 1970s, monetary policy has been the primary macroeconomic stabilization instrument. In light of this fact, many researchers have studied how monetary policy affects asset prices, consumer prices, output, and employment to improve such policy. This large literature has used two main methods to study the effect of monetary shocks on macroeconomic variables: vector autoregressions (VARs) and studies of high-frequency monetary shocks on asset prices.1

VARs offer the advantage of directly studying the effects of monetary policy shocks on key variables-prices, output, and employment-rather than indirectly studying them through their effects on asset prices (see Litterman and Weiss,1985; Strongin,1995; Edelberg and Marshall, 1996; Evans and Marshall, 1998; Bernanke and Mihov, 1998; and Christiano, Eichenbaum, and Evans, 1999). It is difficult to isolate the effects of policy-induced changes in interest rates on monthly or quarterly macroeconomic variables from changes induced by other factors, however, and it is equally difficult to definitively differentiate the effects of monetary policy shocks from the effects of variables to which monetary policy reacts. That is, VAR analysis requires controversial identification assumptions to identify simultaneous causality because time aggregation of data to lower frequencies-such as the monthly or quarterly data used in VAR analysis-generally produces simultaneous causality in economic data even if there is unidirectional causality at very high frequencies. In other words, although it is unlikely that macro variables or asset price changes within the meeting day influence Federal Open Market Committee (FOMC) policy decisions, asset price changes in the weeks before such decisions very likely have influenced such decisions. The combination of simultaneity and the omission of many variables that affect asset prices inherently leave a great deal of uncertainty about the effect of monetary policy on monthly prices, output, and employment.

It is far easier to identify the effect of high-frequency (daily, hourly) monetary shocks on asset prices. If the monetary policy instrument and market expectations for its value are known, then it is possible to characterize the impact of monetary policy shocks-deviations from expectations-on asset prices, which react quickly to news and transmit monetary policy to the economy. Because financial markets are forward looking, one would normally expect asset prices to react only to the unexpected portion of monetary policy changes, as the expected portion would already be priced into assets. Such high-frequency studies of the effect of monetary shocks on asset prices interest both market participants and economists and constitute a useful first step to answering larger questions about the effects of monetary policy on macro variables.

Why study the effect of monetary policy shocks when systematic monetary policy presumably has greater total effects? Both systematic and unsystematic policy actions might be expected to affect asset prices. However, the effects of the systematic policy arise as new information (e.g., data releases, policy statements) becomes available and reshapes market expectations about the economy and the likely policy reaction. These expectations about economic conditions and the central banks reaction function form over time and are influenced by both monetary and nonmonetary events. Therefore, it is very difficult to estimate the effects of these unobservable changes in expectations of systematic monetary policy on asset prices, though they will have an effect. In contrast, when a central bank makes a discrete change to policy, the monetary surprise changes expectations immediately-by definitionand it is easy to determine the effects of such surprises on asset prices, which inform us about the transmission of all monetary policy.

Such investigations have proliferated since the seminal work of Kuttner (2001), but efforts to draw those lessons together have been only limited and fragmented. …

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