Monetary Policy Surprises, Economic Activity and Asset Prices

This study contributes to the empirical literature on monetary policy by providing a comprehensive analysis of its causal effects on asset prices and macroeconomic activity. Employing a novel high-frequency identification strategy, the paper isolates monetary policy surprises using daily movements in Treasury yields within narrow windows around policy announcements. Spanning an extensive historical period from 1952 to 2020, the analysis leverages newly digitized financial data, enabling an investigation into the evolving impacts of monetary policy over time.

A key innovation lies in the decomposition of monetary policy shocks into two distinct components: the “classical” shocks that affect the current short-term rate and forward-path shocks that influence expectations of the future trajectory of short-term rates. This dual-shock framework captures the multidimensional effects of monetary policy on the yield curve, as highlighted by prior research. The study demonstrates that forward-path shocks, which have grown in importance since the 1990s, are critical drivers of corporate bond spreads and equity returns, while classical shocks predominantly affect short-term yields.

The empirical findings reveal significant implications for the transmission mechanisms of monetary policy. Contractionary classical shocks lead to substantial declines in industrial production, employment, and price levels, with the effects found to be more pronounced during recessions than expansions. Moreover, the study uncovers historical shifts in the sensitivity of asset prices to monetary policy, with equity returns exhibiting significant responses only since the 1980s. While the impact on Treasury yields has remained relatively stable, the importance of forward-path shocks in shaping corporate bond spreads and equity returns has markedly increased over time.

By employing a robust econometric framework and accounting for the complex dynamics of the yield curve, this paper offers a nuanced understanding of monetary policy’s role in influencing financial markets and macroeconomic outcomes. The findings not only enhance the theoretical understanding of monetary transmission mechanisms but also provide critical insights for policymakers, emphasizing the need to consider the time-varying and state-dependent nature of monetary policy effects.

Please find the code for the project here