The Fed's Effect on Excess Returns and Inflation is Much Bigger Than You Think

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Abstract
We find that between 20 and 25 percent of the negative covariance between excess returns and inflation is explained by shocks to monetary policy variables. The finding is robust to changes in the monetary policy rule that have occurred during the 1966-2000 period. The result contradicts the theory that money supply shocks induce a positive correlation between inflation and returns. Our findings also cast doubt on models that explain the negative correlation in a money-neutral environment (Boudoukh, Richardson, And Whitelaw (1994)), and on models that account for this correlation as being due solely to money demand shocks (Fama (1981), Marshall (1992)). We argue that contractionary monetary policy lowers excess stock market returns through various channels. Furthermore, if fed shocks raise the borrowing costs of firms or if the fed has some private information about future inflation, then a contractionary monetary shock will be followed by an increase in inflation, in the short run. The combined effect is a negative inflation/excess returns correlation. The results lend support to the argument that if asset pricing models are to capture the observed negative correlation, they must incorporate monetary policy effects.

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