Authors: Nikiforos Laopodis

Title: The Fed’s Policy Reaction Function and U.S. Stock Returns

Abstract

This paper examines the dynamic linkages between monetary policy and the stock market during the three monetary regimes of Volcker, Greenspan and Bernanke. The empirical findings from the benchmark model indicated that there were distinct reactions of stock returns to fed funds rate shocks during each monetary regime. These reactions appeared more turbulent and persistent during the Bernanke regime than during the previous ones. Thus, it can be concluded that monetary policy had real and significant (short-run) effects on the stock market in all three monetary regimes. When augmenting the Fed’s reaction function with variables such as stock returns, yield spreads, unemployment, and a measure of financial uncertainty it was revealed that the Fed might have actually considered each of these magnitudes separately in its deliberations to conduct monetary policy. Finally, stock returns were seen to react differently during various expansions and contractions but their reactions were also dissimilar during each expansion and contraction.