The Cross-Section of Stock Returns and Monetary Policy

Abstract

This study investigates whether monetary policy factors are critical for understanding the cross-section of expected returns in stock markets from 1954Q1 to 2011Q1. Equipped with misspecification-robust statistics, I show that the permanent monetary policy shocks to inflation target have independent explanatory power at 1% level for the expected returns on 25 portfolios sorted on size and book-to-market ratio. The price of covariance risk for the HML factor loses it significance with robust t-statistics. The estimated premium and the price of covariance risk for the temporary monetary policy factor indicate that it explains momentum, albeit less significantly, with misspecification-robust t-statistics. An economic rational for the two monetary factors is provided by the capital market imperfection hypothesis.

Keywords: Monetary Policy, Capital Market Imperfections, the Size and Value Premium, Momentum Premium, Misspecification-Robust Inference

JEL Classification: E32, E52, G12