Monetary Policy Shocks and Security Market Responses

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Abstract
An old and unanswered question is: how does monetary policy work? This paper contributes to a growing recent literature that tries to quantify the first step of the process. These studies use daily data to estimate the response of security prices-bond yields and equity returns - to exogenous monetary policy surprises. We extend the literature in three directions: (1) theory: we specify a general factor model in which security prices respond to multiple sources of systematic risk - monetary policy surprises and other market wide information shocks - and idiosyncratic risk. (2) Empirical: we use all of the daily data while other studies use a small sub-sample of less than 10% of the data. And (3) econometric: we estimate a vector model and impose the over-identifying restrictions. Our empirical results show that efficiently estimating a more general model leads to economically important differences. Our results solve a puzzle and highlight an important neglected short-run channel of monetary policy. Cochrane and Piazzesi (2002), the latest of many, found that long maturity bond yields increase in response to a surprise tightening in monetary policy - a result they properly label a puzzle. Our results eliminate the puzzle. The yield curve response to a monetary surprise displays the classical textbook pattern - short maturity yields rise and long maturity yields do nothing. Common information shocks have a level effect on the yield curve - all yields increase in response to a positive shock. We also find that the equity market, which is ignored in most studies and textbooks, is quantitatively the most important channel for monetary policy in the short run. The wealth effect from a monetary surprise in the equity market dwarfs the wealth effect in debt markets.