Monetary Policy Surprises, Investment Opportunities, and Asset Prices

Abstract

I use changes in Federal funds futures rates on days of FOMC announcements to isolate monetary policy shocks. Recent evidence suggests that contractionary (positive) monetary policy shocks increase expected excess market returns. All else equal, standard intertemporal asset pricing theory predicts that these shocks should therefore earn a positive risk premium as long-lived investors will pay to hedge against decreases in expected returns. Consistent with this prediction, I find that a mimicking portfolio for these shocks earns positive average excess returns, and along with the market factor prices portfolios formed on size, book-to- market, and momentum with an R2 of 86%. The policy shock portfolio also eliminates the alphas of value and momentum factors.