We analyze the effect of monetary policy on yield spreads between corporate bonds with different credit ratings over the business cycle. We use futures contracts to distinguish between expected and unexpected changes in the Fed funds target rate and several indicators to distinguish between different phases of the business cycle. In line with the predictions of imperfect capital market theories, we find that yields on corporate bonds with low credit ratings widen (narrow) with respect to those with high credit ratings following an unexpected increase (decrease) in the Fed funds target rate during recession periods. Several tests suggest that our results are robust to outliers, potential endogeneity problems, empirical specification, control variables, countercyclical risk premium in futures, and alternative definitions of credit spreads and economic conditions. Significant at the 10% level. t is the monthly return on the S&P 500 index. Panel A presents results based on the NBER recession dummy variable (NBER t ), which equals 1 if the economy is in a recession in month t as defined by the NBER, and 0 otherwise. Panel B presents results based on the (log) growth rate of industrial production ( ln IP t ). Panel C presents results based on the real-time recession probabilities from the estimation of equation (1). Panel D presents results based on the real-time recession probabilities from Chauvet and Piger (2008). The coefficients are estimated via OLS with HAC standard errors.

This paper empirically investigates the following three questions: (i) Do stock returns respond to monetary policy shocks? (ii) Do stock returns alter the transmission mechanism of monetary policy? and (iii) Does monetary policy systematically react to stock returns? Existing research based on event studies and Structural Vector Auto-Regressions (SVAR) documents that stock returns increase significantly following an unanticipated monetary policy expansion. However, this literature did not explore whether or not stock returns matter for the choice of monetary policy or its propagation mechanism. In this paper, we use a SVAR that relaxes the restrictions commonly imposed in earlier studies and identify monetary policy shocks by exploiting the conditional heteroscedasticity of the structural innovations. Applying this method to U.S. data, we reach a surprising and puzzling conclusion: the answers to the three questions above are No, No, and No!

We analyze the effect of monetary policy on yield spreads between corporate bonds with different credit ratings over the business cycle. We use futures contracts to distinguish between expected and unexpected changes in the Fed funds target rate and several indicators to distinguish between different phases of the business cycle. In line with the predictions of imperfect capital market theories, we find that yields on corporate bonds with low credit ratings widen (narrow) with respect to those with high credit ratings following an unexpected increase (decrease) in the Fed funds target rate during recession periods. Several tests suggest that our results are robust to outliers, potential endogeneity problems, empirical specification, control variables, countercyclical risk premium in futures, and alternative definitions of credit spreads and economic conditions.

No abstract

Abstract:This paper empirically investigates the following three questions: (i) Do stock returns respond to monetary policy shocks? (ii) Do stock returns alter the transmission mechanism of monetary policy? and (iii) Does monetary policy systematically react to stock returns? Existing research based on event studies and Structural Vector AutoRegressions (SVAR) documents that stock returns increase significantly following an unanticipated monetary policy expansion. However, this literature did not explore whether or not stock returns matter for the choice of monetary policy or its propagation mechanism. In this paper, we use a SVAR that relaxes the restrictions commonly imposed in earlier studies and identify monetary policy shocks by exploiting the conditional heteroscedasticity of the structural innovations. Applying this method to U.S. data, we reach a surprising and puzzling conclusion: the answers to the three questions above are No, No, and No!