Working Paper: NBER ID: w27856
Authors: Carolin Pflueger; Gianluca Rinaldi
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.
Keywords: monetary policy; risk aversion; stock market; FOMC announcements
JEL Codes: E43; E44; E52; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| surprise increase in the short-term interest rate (E43) | decline in output (E23) |
| decline in output (E23) | increase in risk aversion among investors (G41) |
| increase in risk aversion among investors (G41) | greater decline in stock prices (G10) |
| increase in long-term breakeven inflation (E31) | increase in stock returns (G17) |
| bad economic times (E32) | stronger stock market reaction to monetary policy (E52) |
| monetary policy announcements (E60) | reveal information about long-term inflation and economic activity (E31) |