The Federal Reserve and the Cross Section of Stock Returns

Abstract

We analyze the effects of monetary policy on the equity premium and the cross-section of stock returns in a general equilibrium framework. Monetary policy is conducted using an interest-rate policy rule reacting to inflation and has real effects due to nominal rigidities in the production sector. The model predicts that higher price rigidities and lower policy responses to inflation generate higher equity premiums. Moreover, industries with lower price rigidities earn higher expected returns than industries with higher price rigidities. We provide a consumption-based explanation for this result. Real profits of industries with low rigidities are more sensitive to monetary policy shocks than profits of industries with high rigidities. Since profits are positively correlated with aggregate consumption, investors require higher compensations for holding stocks with lower profits when marginal utility is high. In addition, the difference in expected returns between high and low rigidity industries decreases when the response of monetary policy to inflation is more aggressive. We find empirical evidence supporting all model's predictions.

Keywords: General Equilibrium, Cross Section of Returns, Monetary Policy, Price Stickiness

JEL Classification: G12, E52