Why Does the Fed Move Markets so Much? A Model of Monetary Policy and Time-Varying Risk Aversion
Thu, 25 March, 2021
2:30pm - 4:00pm
Wednesday, April 7, 2021
02:30 p.m. – 04:00 p.m.
via Zoom
The same habit preferences that explain the equity volatility puzzle in quarterly data also naturally explain large high-frequency stock responses to monetary policy news. To show this, we newly integrate a work-horse New Keynesian model with habit formation preferences. The model generates endogenously time-varying risk premia from level shocks to interest rates because a surprise increase in the short-term interest rate lowers output and consumption relative to habit, raising risk aversion and amplifying the fall in stocks. The model explains the positive comovement between long-term breakeven and stocks on FOMC dates with news about long-term inflation.