Why does the Fed move markets so much? A model of monetary policy and time-varying risk aversion

Carolin Pflueger and Gianluca Rinaldi

Journal of Financial Economics, 2022, vol. 146, issue 1, 71-89

Abstract: We show that endogenous variation in risk aversion over the business cycle can jointly explain financial market responses to high-frequency monetary policy shocks with standard asset pricing moments. We newly integrate a work-horse New Keynesian model with countercyclical risk aversion via habit formation preferences. In the model, a surprise increase in the policy rate lowers consumption relative to habit, raising risk aversion. Endogenously time-varying risk aversion in the model is crucial to explain the large fall in the stock market, the cross-section of industry returns, and the increase in long-term bond yields in response to a surprise policy rate increase.

Keywords: FOMC announcement; stock return; bond yield; habit-formation preferences; New Keynesian (search for similar items in EconPapers)
JEL-codes: E2 E43 G12 (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (8)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:146:y:2022:i:1:p:71-89

DOI: 10.1016/j.jfineco.2022.06.002

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