Stock Prices, Firm Size, and Changes in the Federal Funds Rate Target
FRB St. Louis Working Paper No. 2002-004A
30 Pages Posted: 20 Feb 2002
Date Written: January 2002
The Fed targeted the federal funds rate during the period 1974-79; they returned to that procedure in the late 1980s and have maintained it since then. For both periods, we find that stock prices reacted significantly to unanticipated changes in the federal funds rate target, but not to anticipated ones. Consistent with the prediction of imperfect capital market theories, the estimated impact of monetary shocks decreased with firm size in the late 1970s, when business conditions were typically bad; however, we do not observe such a "size effect" in the 1990s, when business conditions were typically good. Our results thus provide additional support to recent rationales for abnormal returns on value stocks: small stocks on average earn higher risk-adjusted returns than large stocks do because small firms are more vulnerable to liquidity constraints and thus perform worse during economic downturns, but not during expansions.
Keywords: monetary transmission, credit market imperfection, changes in federal funds rate target
JEL Classification: E44, E58, G12
Suggested Citation: Suggested Citation