The Fed and the stock market: A tale of sentiment states

doi:10.1016/j.jimonfin.2022.102707

Journal of International Money and Finance

Volume 128, November 2022, 102707

https://doi.org/10.1016/j.jimonfin.2022.102707 Get rights and content

Under a Creative Commons license

open access

Highlights

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The impact of Federal funds rate surprises is mostly potent when sentiment-driven overvaluation is followed by a correction.
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Monetary easing surprises boost the stock market by alleviating investors’ fear.
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The ability of sentiment to drive the observed state dependence is hard to reconcile with rational pricing.

Abstract

We analyze the period before the zero lower bound and show that the state of investor sentiment strongly affects the transmission of monetary policy to the stock market. The impact of Federal funds rate (FFR) surprises is mostly potent when sentiment-driven overvaluation is followed by a correction, whereby the stock market increases by 0.8% in response to an unexpected FFR cut of 10 basis points. Our findings suggest that monetary easing surprises during sentiment-waning phases boost the stock market by alleviating investors’ fear. The ability of sentiment to drive the observed state dependence is hard to reconcile with rational pricing.

Keywords

Investor Sentiment

Monetary Policy Surprises

Event Study

JEL classification:

E52

G12

G14

Cited by (0)

: We thank Panayiotis Andreou, Malcolm Baker, Jerry Coakley, Chris Florackis, Alexandros Kostakis, Alexander Kurov, Paulo Maio, William Megginson, Alberto Montagnoli, Kjell Nyborg, Stefan Ruenzi, Antonios Siganos, Eric Swanson, Evangelos Vagenas-Nanos, Patrick Verwijmeren, Nikos Vlastakis, Jeffrey Wurgler, conference participants at the 2019 Financial Management and Accounting Research Conference, the 2019 Infiniti Conference, the 3rd Israel Behavioural Finance Conference, the 23rd Conference on Macroeconomic Analysis and International Finance, the 2018 Financial Management Association Conference, the 2018 Financial Stability and Banking Conference, the 2017 Financial Management Association Asian Conference, the 2017 European Financial Management Association Conference, the 7th International Conference of the Financial Engineering and Banking Society, the 2017 World Banking and Finance Symposium, the 2017 Behavioural Finance Working Group Conference, the 2017 Conference on the Theories and Practises of Securities and Financial Markets, and seminar participants at National Bank of Slovakia, Middlesex University, University of Essex, University of Glasgow, Nankai University and National Cheng Kung University for useful comments and suggestions.