Monetary Policy Shocks and Portfolio Choice

Working Paper: CEPR ID: DP8099

Authors: Marcel Fratzscher; Christian Saborowski; Roland Straub

Abstract: The paper shows that monetary policy shocks exert a substantial effect on the size and composition of capital flows and the trade balance for the United States, with a 100 basis point easing raising net capital inflows and lowering the trade balance by 1% of GDP, and explaining about 20-25% of their time variation. Monetary policy easing causes positive returns to both equities and bonds. Yet such a monetary policy easing shock also induces a shift in portfolio composition out of equities and into bonds, implying a negative conditional correlation between flows in equities and bonds. Moreover, such shocks induce a negative conditional correlation between equity flows and equity returns, but a positive conditional correlation between bond flows and bond returns. The findings thus provide evidence for the presence of a portfolio rebalancing motive behind investment decisions in equities, but the dominance of what is akin to a return chasing motive for bonds, conditional on monetary policy shocks. The results also shed light on the puzzle of the strongly time-varying equity-bond return correlations found in the literature.

Keywords: asset prices; capital flows; monetary policy; portfolio choice; sign restrictions; trade balance; united states; vector autoregressions

JEL Codes: E52; F32; F4; G1

Causal Claims

Cause	Effect
U.S. monetary policy shocks (E39)	net capital inflows (F21)
U.S. monetary policy shocks (E39)	U.S. trade balance (F14)
U.S. monetary policy shocks (E39)	equity returns (G12)
equity returns (G12)	private consumption (D19)
private consumption (D19)	U.S. trade balance (F14)
U.S. monetary policy shocks (E39)	portfolio equity flows (F21)
U.S. monetary policy shocks (E39)	debt flows (F32)
equity returns (G12)	bond returns (G12)
bond flows (G12)	bond returns (G12)