Stock Market Reaction to Fed Funds Rate Surprises: State Dependence and the Financial Crisis

Posted: 30 Jun 2015

See all articles by Aman Saggu

Aman Saggu

Mahidol University - International College; United Nations - Economic and Social Commission for Asia and the Pacific (ESCAP); University of Glasgow - Adam Smith Business School; University of St. Andrews - School of Economics and Finance; London School of Economics & Political Science (LSE) - Department of Finance; University of London, Royal Holloway College - Department of Economics

Alexandros Kontonikas

University of Glasgow - Department of Economics

Ronald MacDonald

University of Glasgow - Adam Smith Business School

Date Written: November 30, 2013

Abstract

This paper examines the response of US stock returns to Federal Funds rate (FFR) surprises between 1989 and 2012, focusing on the impact of the recent financial crisis. We find that outside the crisis period, stock prices increased as a response to unexpected FFR cuts. State dependence is identified with stocks exhibiting larger increases when interest rate easing coincided with recessions, bear markets, and tightening credit conditions. However, an important structural shift occurred during the crisis, changing the stocks’ response to FFR shocks and the nature of state dependence. Throughout the crisis period, stocks did not react positively to unexpected FFR cuts, which were interpreted as signals of worsening future economic conditions. This triggered a rebalancing of investment portfolios away from falling equities and towards safe-haven assets. Our results highlight the severity of the crisis and the ineffectiveness of conventional monetary policy close to the zero lower bound.

Keywords: Monetary policy; Stock market; State dependence; Flight to safety; Financial crisis

JEL Classification: C32; E44; E52; G01; G14

Suggested Citation

Saggu, Aman and Kontonikas, Alexandros and MacDonald, Ronald, Stock Market Reaction to Fed Funds Rate Surprises: State Dependence and the Financial Crisis (November 30, 2013). Journal of Banking and Finance, Vol. 37, No. 11, 2013. Available at SSRN: https://ssrn.com/abstract=2624482

Aman Saggu (Contact Author)

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London School of Economics & Political Science (LSE) - Department of Finance ( email )

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Alexandros Kontonikas

University of Glasgow - Department of Economics ( email )

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Ronald MacDonald

University of Glasgow - Adam Smith Business School ( email )

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