How important is the Fed information effect? Evidence from the corporate bond market

Abstract

Does expansionary monetary policy drive up risky asset prices? Or, do investors interpret policy easing as a signal that economic fundamentals are weaker than they previously believed, thus lowering risky asset prices? We test the relative strength of these two forces within the U.S. corporate bond market and find strong evidence that the second force—known as the “Fed information effect”—empirically dominates. In particular, following an unanticipated monetary policy tightening (easing), riskier corporate bonds outperform (underperform) safer corporate bonds. We conclude that monetary policy surprises are predominantly interpreted by market participants as signaling information about economic fundamentals.

Keywords: monetary policy, corporate bonds, reaching for yield, Federal Reserve information

JEL Classification: E40, E52, G12, G14