Why Does the Fed Move Markets so Much? A Model of Monetary Policy and Time-Varying Risk Aversion

Carolin Pflueger and Gianluca Rinaldi

No 27856, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We build a new model integrating a work-horse New Keynesian model with investor risk aversion that moves with the business cycle. We show that the same habit preferences that explain the equity volatility puzzle in quarterly data also naturally explain the large high-frequency stock response to Federal Funds rate surprises. In the model, a surprise increase in the short-term interest rate lowers output and consumption relative to habit, thereby raising risk aversion and amplifying the fall in stocks. The model explains the positive correlation between changes in breakeven inflation and stock returns around monetary policy announcements with long-term inflation news.

JEL-codes: E43 E44 E52 G12 (search for similar items in EconPapers)
Date: 2020-09
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-upt
Note: AP ME
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Published as Carolin Pflueger & Gianluca Rinaldi, 2022. "Why does the Fed move markets so much? A model of monetary policy and time-varying risk aversion," Journal of Financial Economics, vol 146(1), pages 71-89.

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