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The Time Varying Effect of Monetary Policy Surprise on Stock Returns: Bursting Bubble Beating Forward Guidance

We study the time varying effects of monetary policy on the stock returns in order to capture changes in the effectiveness of monetary policy over time. We find that a one percentage point surprise federal funds rate increase decreases the one-day stock return by 1.33% during the period 1989 to 2000, and by 7.47% during the period 2001 to 2007, i.e., over five times more. Also, surprises of monetary policy announcements do not have significant effects on the stock returns for most of the 1990s, but have significant effects during the 2000s. The significant period coincides with higher transparency and greater efforts from the Federal Reserve to communicate with the public, especially in the grounds of future policy, i.e., forward guidance. Higher transparency could increase the effectiveness of monetary policy. At the same time, the insignificant period coincides with the period of stock prices’ bubble. Recent work (Gali, 2014; Gali and Gambetti, 2015) has suggested that monetary policy might be ineffective during periods of bubbles. In order to distinguish between the two explanations, we explore the evolution effect of monetary policy surprise on bond returns. We find uniform response of bond returns before and after the 2000s. Thus, we conclude that our finding of low monetary policy effectiveness during the 1990s is specific to the stock market, making the theory of rational bubbles the prevailed explanation.